1
CHAPTER
PART 1 INTRODUCTION
Why Study Financial Markets
and Institutions?
PREVIEW
On the evening news you have just heard that the
panies, mutual funds, and other institutions) work.
bond market has been booming. Does this mean that
Financial markets and institutions not only affect
interest rates will fall so that it is easier for you to
your everyday life but also involve huge flows of
finance the purchase of a new computer system for
funds—trillions of dollars—throughout our economy,
your small retail business? Will the economy improve
which in turn affect business profits, the produc-
in the future so that it is a good time to build a new
tion of goods and services, and even the economic
building or add to the one you are in? Should you try
well-being of countries other than the United States.
to raise funds by issuing stocks or bonds, or instead
What happens to financial markets and institutions
go to the bank for a loan? If you import goods from
is of great concern to politicians and can even have
abroad, should you be concerned that they will
a major impact on elections. The study of financial
become more expensive?
markets and institutions will reward you with an
This book provides answers to these ques-
understanding of many exciting issues. In this chap-
tions by examining how financial markets (such
ter we provide a road map of the book by outlining
as those for bonds, stocks, and foreign exchange)
these exciting issues and exploring why they are
and financial institutions (banks, insurance com-
worth studying.
41
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Why Study Financial Markets?
Parts 2 and 5 of this book focus on financial markets, markets in which funds are
transferred from people who have an excess of available funds to people who have
a shortage. Financial markets, such as bond and stock markets, are crucial to promoting greater economic efficiency by channeling funds from people who do not
have a productive use for them to those who do. Indeed, well-functioning financial
markets are a key factor in producing high economic growth, and poorly performing
financial markets are one reason that many countries in the world remain desperately poor. Activities in financial markets also have direct effects on personal wealth,
the behavior of businesses and consumers, and the cyclical performance of the
economy.
Debt Markets and Interest Rates
GO
ONLINE
http://research.stlouisfed
.org/fred2/
The Federal Reserve Bank of
St. Louis’ FRED database provides access to daily, weekly,
monthly, quarterly, and
annual releases and historical
data for selected interest
rates, foreign exchange rates,
and other economic statistics.
A security (also called a financial instrument) is a claim on the issuer’s future
income or assets (any financial claim or piece of property that is subject to ownership). A bond is a debt security that promises to make payments periodically for a
specified period of time.1 Debt markets, also often referred to generically as the bond
market, are especially important to economic activity because they enable corporations and governments to borrow in order to finance their activities; the bond market is also where interest rates are determined. An interest rate is the cost of
borrowing or the price paid for the rental of funds (usually expressed as a percentage of the rental of $100 per year). Many types of interest rates are found in the
economy—mortgage interest rates, car loan rates, and interest rates on many types
of bonds.
Interest rates are important on a number of levels. On a personal level, high
interest rates could deter you from buying a house or a car because the cost of
financing it would be high. Conversely, high interest rates could encourage you to
save because you can earn more interest income by putting aside some of your earnings as savings. On a more general level, interest rates have an impact on the overall
health of the economy because they affect not only consumers’ willingness to spend
or save but also businesses’ investment decisions. High interest rates, for example,
might cause a corporation to postpone building a new plant that would provide more
jobs.
Because changes in interest rates have important effects on individuals, financial institutions, businesses, and the overall economy, it is important to explain fluctuations in interest rates that have been substantial over the past 35 years. For
example, the interest rate on three-month Treasury bills peaked at over 16% in
1981. This interest rate fell to 3% in late 1992 and 1993, and then rose to above 5%
in the mid to late 1990s. It then fell below 1% in 2004, rose to 5% by 2007, only to
fall close to zero from 2008 to 2016.
Because different interest rates have a tendency to move in unison, economists
frequently lump interest rates together and refer to “the” interest rate. As Figure 1.1
1
The definition of bond used throughout this book is the broad one in common use by academics,
which covers both short- and long-term debt instruments. However, some practitioners in financial
markets use the word bond to describe only specific long-term debt instruments, such as corporate
bonds or U.S. Treasury bonds.
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Interest Rate
(% annual rate)
20
15
10
Corporate Baa Bonds
U.S. Government
Long-Term Bonds
5
0
1950
Three-Month
Treasury Bills
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
FIGURE 1.1 Interest Rates on Selected Bonds, 1950–2016
Although different interest rates have a tendency to move in unison, they do often differ substantially and the
spreads between them fluctuate.
Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/TB3MS; https://fred.stlouisfed.org/series/GS10; https://
fred.stlouisfed.org/series/BAA.
shows, however, interest rates on various types of bonds can differ substantially.
The interest rate on three-month Treasury bills, for example, fluctuates more than
the other interest rates and is lower, on average. The interest rate on Baa (mediumquality) corporate bonds is higher, on average, than the other interest rates, and the
spread, or difference, between it and U.S. government long-term bonds became
larger in the 1970s, narrowed in the 1990s and particularly in the middle 2000s, only
to surge to extremely high levels during the global financial crisis of 2007–2009
before narrowing again.
In Chapters 2, 11, 12, and 14 we study the role of debt markets in the economy,
and in Chapters 3 through 5 we examine what an interest rate is, how the common
movements in interest rates come about, and why the interest rates on different
bonds vary.
The Stock Market
A common stock (typically just called a stock) represents a share of ownership in
a corporation. It is a security that is a claim on the earnings and assets of the corporation. Issuing stock and selling it to the public is a way for corporations to raise
funds to finance their activities. The stock market, in which claims on the earnings
of corporations (shares of stock) are traded, is the most widely followed financial
market in almost every country that has one; that’s why it is often called simply “the
market.” A big swing in the prices of shares in the stock market is always a major
story on the evening news. People often speculate on where the market is heading
and get very excited when they can brag about their latest “big killing,” but they
become depressed when they suffer a big loss. The attention the market receives
can probably be best explained by one simple fact: It is a place where people can get
rich—or poor—quickly.
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Introduction
Dow Jones
Industrial Average
20,000
18,000
16,000
14,000
12,000
10,000
8,000
6,000
4,000
2,000
0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
FIGURE 1.2 Stock Prices as Measured by the Dow Jones Industrial Average,
1950–2016
Stock prices are extremely volatile.
Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/DJIA.
As Figure 1.2 indicates, stock prices are extremely volatile. After the market
rose in the 1980s, on “Black Monday,” October 19, 1987, it experienced the worst
one-day drop in its entire history, with the Dow Jones Industrial Average (DJIA)
falling by 22%. From then until 2000, the stock market experienced one of the great
bull markets in its history, with the Dow climbing to a peak of over 11,000. With the
collapse of the high-tech bubble in 2000, the stock market fell sharply, dropping by
over 30% by late 2002. It then rose above the 14,000 level in 2007, only to fall by
over 50% of its value to a low below 7,000 in 2009. Then another bull market began,
with the Dow rising above the 18,000 level in 2016. These considerable fluctuations
in stock prices affect the size of people’s wealth and as a result may affect their
willingness to spend.
The stock market is also an important factor in business investment decisions
because the price of shares affects the amount of funds that can be raised by selling
newly issued stock to finance investment spending. A higher price for a firm’s shares
means that it can raise a larger amount of funds, which can be used to buy production facilities and equipment.
In Chapter 2 we examine the role that the stock market plays in the financial
system, and we return to the issue of how stock prices behave and respond to information in the marketplace in Chapters 6 and 13.
The Foreign Exchange Market
For funds to be transferred from one country to another, they have to be converted
from the currency in the country of origin (say, dollars) into the currency of the
country they are going to (say, euros). The foreign exchange market is where
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this conversion takes place, so it is instrumental in moving funds between countries.
It is also important because it is where the foreign exchange rate, the price of one
country’s currency in terms of another’s, is determined.
Figure 1.3 shows the exchange rate for the U.S. dollar from 1973 to 2016 (measured as the value of the U.S. dollar in terms of a basket of major foreign currencies). The fluctuations in prices in this market have also been substantial: The
dollar’s value reached a low point in the 1978–1980 period and then appreciated
dramatically until early 1985. It then declined again, reaching another low in 1995,
but appreciated from 1995 to 2001. From 2001 to 2008, the dollar depreciated substantially. After a temporary upturn in 2008 and 2009, the dollar fell back down, but
then appreciated from mid-2014 to 2016.
What have these fluctuations in the exchange rate meant to the American
public and businesses? A change in the exchange rate has a direct effect on
American consumers because it affects the cost of imports. In 2001, when the euro
was worth around 85 cents, 100 euros of European goods (say, French wine) cost
$85. When the dollar subsequently weakened, raising the cost of a euro to $1.50,
the same 100 euros of wine now cost $150. Thus, a weaker dollar leads to more
expensive foreign goods, makes vacationing abroad more expensive, and raises
the cost of indulging your desire for imported delicacies. When the value of the
dollar drops, Americans decrease their purchases of foreign goods and increase
their consumption of domestic goods (such as travel in the United States or
American-made wine).
Conversely, a strong dollar means that U.S. goods exported abroad will cost
more in foreign countries, and hence foreigners will buy fewer of them. Exports of
steel, for example, declined sharply when the dollar strengthened in the 1980–1985
and 1995–2001 periods. A strong dollar benefited American consumers by making
foreign goods cheaper but hurt American businesses and eliminated some jobs by
cutting both domestic and foreign sales of their products. The decline in the value
of the dollar from 1985 to 1995 and from 2001 to 2014 had the opposite effect: It
Index
(March 1973 = 100)
150
135
120
105
90
75
1975
1980
1985
1990
1995
2000
2005
2010
2015
FIGURE 1.3 Exchange Rate of the U.S. Dollar, 1973–2016
The value of the U.S. dollar relative to other currencies has fluctuated substantially over the years.
Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/TWEXMMTH.
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made foreign goods more expensive but made American businesses more competitive. Fluctuations in the foreign exchange markets thus have major consequences
for the American economy.
In Chapter 15 we study how exchange rates are determined in the foreign
exchange market, in which dollars are bought and sold for foreign currencies.
Why Study Financial Institutions?
The second major focus of this book is financial institutions. Financial institutions
are what make financial markets work. Without them, financial markets would not
be able to move funds from people who save to people who have productive investment opportunities. Financial institutions thus play a crucial role in improving the
efficiency of the economy.
Structure of the Financial System
The financial system is complex, comprising many types of private-sector financial
institutions, including banks, insurance companies, mutual funds, finance companies, and investment banks—all of which are heavily regulated by the government.
If you wanted to make a loan to Apple or Amazon, for example, you would not go
directly to the president of the company and offer a loan. Instead, you would lend
to such companies indirectly through financial intermediaries, institutions
such as commercial banks, savings and loan associations, mutual savings banks,
credit unions, insurance companies, mutual funds, pension funds, and finance
companies that borrow funds from people who have saved and in turn make loans
to others.
Why are financial intermediaries so crucial to well-functioning financial markets? Why do they give credit to one party but not to another? Why do they usually
write complicated legal documents when they extend loans? Why are they the most
heavily regulated businesses in the economy?
We answer these questions by developing a coherent framework for analyzing
financial structure both in the United States and in the rest of the world in Chapter 7.
Financial Crises
At times, the financial system seizes up and produces financial crises, major disruptions in financial markets that are characterized by sharp declines in asset prices
and the failures of many financial and nonfinancial firms. Financial crises have been
a feature of capitalist economies for hundreds of years and are typically followed by
the most serious business cycle downturns. From 2007 to 2009, the U.S. economy
was hit by the worst financial crisis since the Great Depression. Defaults in subprime
residential mortgages led to major losses in financial institutions, not only producing
numerous bank failures but also leading to the demise of Bear Stearns and Lehman
Brothers, two of the largest investment banks in the United States. The result of the
crisis was the worst recession since World War II, which is now referred to as the
“Great Recession.”
Why these crises occur and why they do so much damage to the economy is
discussed in Chapter 8.
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Central Banks and the Conduct
of Monetary Policy
GO
ONLINE
www.federalreserve.gov
Access general information
as well as monetary policy,
banking system, research,
and economic data of the
Federal Reserve.
The most important financial institution in the financial system is the central bank,
the government agency responsible for the conduct of monetary policy, which in the
United States is the Federal Reserve System (also called simply the Fed).
Monetary policy involves the management of interest rates and the quantity of
money, also referred to as the money supply (defined as anything that is generally
accepted in payment for goods and services or in the repayment of debt). Because
monetary policy affects interest rates, inflation, and business cycles, all of which
have a major impact on financial markets and institutions, we study how monetary
policy is conducted by central banks in both the United States and abroad in
Chapters 9 and 10.
The International Financial System
The tremendous increase in capital flows between countries means that the international financial system has a growing impact on domestic economies. Whether a
country fixes its exchange rate to that of another is an important determinant of
how monetary policy is conducted. Whether there are capital controls that restrict
mobility of capital across national borders has a large effect on domestic financial
systems and the performance of the economy. What role international financial
institutions such as the International Monetary Fund should play in the international
financial system is very controversial. All of these issues are explored in Chapter 16.
Banks and Other Financial Institutions
Banks are financial institutions that accept deposits and make loans. Included
under the term banks are firms such as commercial banks, savings and loan associations, mutual savings banks, and credit unions. Banks are the financial intermediaries that the average person interacts with most frequently. A person who needs
a loan to buy a house or a car usually obtains it from a local bank. Most Americans
keep a large proportion of their financial wealth in banks in the form of checking
accounts, savings accounts, or other types of bank deposits. Because banks are the
largest financial intermediaries in our economy, they deserve careful study. However,
banks are not the only important financial institutions. Indeed, in recent years, other
financial institutions such as insurance companies, finance companies, pension
funds, mutual funds, and investment banks have been growing at the expense of
banks, and so we need to study them as well. We study banks and all these other
institutions in Parts 6 and 7.
Financial Innovation
In the good old days, when you took cash out of the bank or wanted to check your
account balance, you got to say hello to a friendly human. Nowadays, you are more
likely to interact with an automatic teller machine (ATM) when withdrawing cash
and to use your home computer to check your account balance. Financial
innovation, the development of new financial products and services, can be an
important force for good by making the financial system more efficient. Unfortunately,
as we will see in Chapter 8, financial innovation can have a dark side: It can lead to
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Introduction
devastating financial crises, such as the one experienced from 2007 to 2009. In
Chapter 19 we study why and how financial innovation takes place, with particular
emphasis on how the dramatic improvements in information technology have led to
new financial products and the ability to deliver financial services electronically, in
what has become known as e-finance. We also study financial innovation because
it shows us how creative thinking on the part of financial institutions can lead to
higher profits but can sometimes result in financial disasters. By seeing how and
why financial institutions have been creative in the past, we obtain a better grasp of
how they may be creative in the future. This knowledge provides us with useful
clues about how the financial system may change over time and will help keep our
understanding about banks and other financial institutions from becoming obsolete.
Managing Risk in Financial Institutions
In the past ten years, the economic environment has become an increasingly risky
place. Interest rates fluctuated wildly, stock markets crashed both here and abroad,
speculative crises occurred in the foreign exchange markets, and failures of financial
institutions reached levels unprecedented since the Great Depression. To avoid wild
swings in profitability (and even possibly failure) resulting from this environment,
financial institutions must be concerned with how to cope with increased risk.
We look at techniques that these institutions use when they engage in risk management in Chapter 23. Then in Chapter 24, we look at how these institutions make use
of new financial instruments, such as financial futures, options, and swaps, to
manage risk.
Applied Managerial Perspective
Another reason for studying financial institutions is that they are among the largest
employers in the country and frequently pay very high salaries. Hence, some of you
have a very practical reason for studying financial institutions: It may help you get
a good job in the financial sector. Even if your interests lie elsewhere, you should
still care about how financial institutions are run because there will be many times
in your life, as an individual, an employee, or the owner of a business, when you will
interact with these institutions. Knowing how financial institutions are managed
may help you get a better deal when you need to borrow from them or if you decide
to supply them with funds.
This book emphasizes an applied managerial perspective in teaching you about
financial markets and institutions by including special case applications headed
“The Practicing Manager.” These cases introduce you to the real-world problems
that managers of financial institutions commonly face and need to solve in their dayto-day jobs. For example, how does the manager of a financial institution come up
with a new financial product that will be profitable? How does a manager of a financial institution manage the risk that the institution faces from fluctuations in interest
rates, stock prices, or foreign exchange rates? Should a manager hire an expert on
Federal Reserve policy making, referred to as a “Fed watcher,” to help the institution discern where monetary policy might be going in the future?
Not only do “The Practicing Manager” cases, which answer these questions and
others like them, provide you with some special analytic tools that you will need if
you make your career at a financial institution, but they also give you a feel for what
a job as the manager of a financial institution is all about.
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How We Will Study Financial Markets and
Institutions
Instead of focusing on a mass of dull facts that will soon become obsolete, this textbook emphasizes a unifying, analytic framework for studying financial markets and
institutions. This framework uses a few basic concepts to help organize your thinking about the determination of asset prices, the structure of financial markets, bank
management, and the role of monetary policy in the economy. The basic concepts
are equilibrium, basic supply and demand analysis to explain behavior in financial
markets, the search for profits, and an approach to financial structure based on
transaction costs and asymmetric information.
The unifying framework used in this book will keep your knowledge from becoming obsolete and make the material more interesting. It will enable you to learn what
really matters without having to memorize material that you will forget soon after
the final exam. This framework will also provide you with the tools needed to understand trends in the financial marketplace and in variables such as interest rates and
exchange rates.
To help you understand and apply the unifying analytic framework, simple models are constructed throughout the text in which the variables held constant are
carefully delineated, each step in the derivation of the model is clearly and carefully
laid out, and the models are then used to explain various phenomena by focusing on
changes in one variable at a time, holding all other variables constant.
To reinforce the models’ usefulness, this text also emphasizes the interaction of
theoretical analysis and empirical data in order to expose you to real-life events and
data. To make the study of financial markets and institutions even more relevant
and to help you learn the material, the book contains, besides “The Practicing
Manager” cases, numerous additional cases and mini-cases that demonstrate how
you can use the analysis in the book to explain many real-world situations.
To function better in the real world outside the classroom, you must have the
tools to follow the financial news that appears in leading financial publications and
on the Web. To help and encourage you to read the financial section of the newspaper, this book contains two special features. The first is a set of special boxed inserts
titled “Following the Financial News” that provide detailed information and definitions you need to evaluate the data that are discussed frequently in the media. This
book also contains nearly 400 end-of-chapter questions and problems that ask you
to apply the analytic concepts you have learned to other real-world issues.
Particularly relevant is a special class of problems headed “Predicting the Future.”
These questions give you an opportunity to review and apply many of the important
financial concepts and tools presented throughout the book.
Exploring the Web
The World Wide Web has become an extremely valuable and convenient resource
for financial research. We emphasize the importance of this tool in several ways.
First, wherever we use the Web to find information to build the charts and tables
that appear throughout the text, we include the source site’s URL. These sites often
contain additional information and are updated frequently. Second, we have
added Web exercises to the end of each chapter. These exercises prompt you to
visit sites related to the chapter and to work with real-time data and information.
We have also supplied Web references to the end of the chapter that list the URLs
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of sites related to the material being discussed. Visit these sites to further explore a
topic you find of particular interest. Website URLs are subject to frequent change.
We have tried to select stable sites, but we realize that even government URLs
change. The publisher’s Website (www.pearsonglobaleditions.com/Mishkin) will
maintain an updated list of current URLs for your reference.
Collecting and Graphing Data
The following Web exercise is especially important because it demonstrates how to
export data from a Website into Microsoft Excel for further analysis. We suggest you
work through this problem on your own so that you will be able to perform this
activity when prompted in subsequent Web exercises whenever you want to collect
data from the Web and apply it to particular situations.
Web Exercise
You have been hired by Risky Ventures, Inc., as a consultant to help the company
analyze interest-rate trends from the beginning of 2015 to the present. Your employers are initially interested in determining the relationship between long- and shortterm interest rates in that year. The biggest task you must immediately undertake
is collecting market interest-rate data. You know the best source of this information
is the Web.
1. You decide that your best indicator of long-term interest rates is that on a
10-year U.S. Treasury note. Your first task is to gather historical data. Go to
the Federal Reserve Bank of St. Louis, FRED database, at http://research
.stlouisfed.org/fred2/, a terrific resource for economic data. In the search
box in the upper right corner, type in “10-year,” and then click on “10-Year
Treasury Constant Maturity Rate” in the drop down box. The site should look
like Figure 1.4.
2. Now that you have located an accurate source of historical interest-rate data,
the next step is choosing the sample period and getting it onto a spreadsheet.
Check “monthly” under “10-year Treasury Constant Maturity Rate.” Change
the beginning observation date to 2015, January. Now click on “Edit Graph”
and then click on “Add Line.” Type in “1-year” in the “Add data series in
the graph” box and hit Enter. Click on “1-Year Treasury Constant Maturity
Rate: Monthly” and click on “Add Series.” Click on “Download” and then on
“Excel (data).” Click on “fedgraph.xls” at the bottom and you will now see
Figure 1.5.
3. You now want to analyze the interest rates by first graphing them. Put headings such as “10-Year Interest Rate” and “1-Year Interest Rate” at the top of
each column of data. Highlight the two columns of interest-rate data you just
created in Excel, including the headings. Click on “Insert” on the toolbar and
then click on the “Insert Line Chart” icon and the first 2-D Line. Put labels in
column A: “Average” and “Standard deviation.” In the same row as you put
the label “Average,” in columns B and C, click on the fx icon on the Excel
toolbar, then click on “AVERAGE” in the Insert Function box and click “OK.”
Highlight the dates for each of the series from January 2015 to the present
and click “OK.” In the same row as you put the label “Standard deviation,”
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FIGURE 1.4 Federal Reserve Bank of St. Louis, FRED Database
Source: https://fred.stlouisfed.org/series/GS10.
FIGURE 1.5 Excel Spreadsheet with Interest-Rate Data
Source: Used with permission from Microsoft Corporation; https://fred.stlouisfed.org/series/GS1; https://fred.stlouisfed.org/series/GS10.
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FIGURE 1.6 Excel Graph of Interest-Data
Source: Used with permission from Microsoft Corporation.
in columns B and C, click on the fx icon on the Excel toolbar, then click on
“STDEV” in the Insert Function box and click “OK.” Highlight the dates for
each of the series from January 2015 to the present and click “OK.” You
should now see Figure 1.6.
Concluding Remarks
The field of financial markets and institutions is an exciting one. Not only will you
develop skills that will be valuable in your career, but you will also gain a clearer
understanding of events in financial markets and institutions you frequently hear
about in the news media. This book will introduce you to many of the controversies
that are hotly debated in the current political arena.
SUMMARY
1. Activities in financial markets have direct effects on
individuals’ wealth, the behavior of businesses, and
the efficiency of our economy. Three financial markets deserve particular attention: the bond market
(where interest rates are determined), the stock
market (which has a major effect on people’s wealth
and on firms’ investment decisions), and the foreign
exchange market (because fluctuations in the foreign
exchange rate have major consequences for the U.S.
economy).
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2. Because monetary policy affects interest rates,
inflation, and business cycles, all of which have an
important impact on financial markets and institutions, we need to understand how monetary policy
is conducted by central banks in the United States
and abroad.
3. Banks and other financial institutions channel funds
from people who might not put them to productive
use to people who can do so and thus play a crucial role in improving the efficiency of the economy.
When the financial system seizes up and produces
a financial crisis, financial firms fail, which causes
severe damage to the economy.
Why Study Financial Markets and Institutions?
53
your life, as an individual, an employee, or the owner
of a business, when you will interact with them. “The
Practicing Manager” cases not only provide special
analytic tools that are useful if you choose a career
with a financial institution but also give you a feel for
what a job as the manager of a financial institution
is all about.
5. This textbook emphasizes an analytic way of thinking by developing a unifying framework for the
study of financial markets and institutions using a
few basic principles. This textbook also focuses on
the interaction of theoretical analysis and empirical
data.
4. Understanding how financial institutions are managed is important because there will be many times in
KEY TERMS
assets, p. 42
banks, p. 47
bond, p. 42
central bank, p. 47
common stock (stock), p. 43
e-finance, p. 48
Federal Reserve System (the Fed),
p. 47
financial crises, p. 46
financial innovation, p. 47
financial intermediaries, p. 46
financial markets, p. 42
foreign exchange market, p. 44
foreign exchange rate, p. 45
interest rate, p. 42
monetary policy, p. 47
money (money supply), p. 47
security, p. 42
QUESTIONS
1. Explain the link between well-performing financial
markets and economic growth. Name one channel
through which financial markets might affect economic growth and poverty.
2. How would banks benefit when interest rates fall?
at Figure 1.3, briefly discuss how the U.S. dollar
exchange rates behave.
10. How do you think financial institutions help financial
markets to work?
3. How does a decline in the value of the pound sterling
affect German consumers in the Eurozone?
11. “A robust financial market is one of the pillars of
stable economic growth and financial sustainability
for the future.” Discuss.
4. How does an increase in the value of the U.S. dollar
affect businesses in the Eurozone?
12. How can monetary policies created by a central bank
affect financial markets and financial institutions?
5. What effect might a fall in stock prices have on business investment?
13. Can you date the latest financial crisis in the United
States or in Europe? Are there reasons to think that
these crises might have been related? Why?
6. Explain the main difference between a bond and a
common stock.
7. Why are stock market conditions usually newsworthy?
14. What is a debt market and how does a bond work
within it?
8. Discuss the role of banks as financial institutions that
fuel the economic growth of a nation.
15. Why is there a need to manage risk in financial
institutions?
9. How can fluctuations in a foreign exchange rate
affect domestic and foreign consumption? Looking
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Q U A N T I TAT I V E P R O B L E M S
1. The following table lists the foreign exchange rates
between the U.S. dollar and the euro (EUR) during
February, 2014.
Date
Date
U.S. Dollars per EUR
U.S. Dollars per EUR
2/15
1.369300
2/16
1.369300
2/17
1.370679
2/1
1.348781
2/18
1.375730
2/2
1.328781
2/19
1.376089
2/3
1.352399
2/20
1.368862
2/4
1.350628
2/21
1.372465
2/5
1.351799
2/22
1.373730
2/6
1.360180
2/23
1.373741
2/7
1.361194
2/24
1.374172
2/8
1.363577
2/25
1.374726
2/9
1.363577
2/26
1.367002
2/10
1.364353
2/27
1.371264
2/11
1.365278
2/28
1.380712
2/12
1.359235
2/13
1.366882
2/14
1.369081
Which day would have been the best day to convert $300 to euros? Which day would have been the
worst? What would the difference be in euro?
WEB EXERCISES
Working with Financial Market Data
1. In this exercise we will practice collecting data from
the Web and graphing it using Excel. Use the example on pages 50–52 as a guide. Go to https://fred
.stlouisfed.org/series/DJIA, and select “10 year
graph” on the top middle. On the far right select
“Edit Graph.” Choose “modify frequency” and select
“Monthly.” Click on the X on the top right to return
to the graph and then choose “Download” and then
“Excel(data)” from the drop down.
a. Using the method presented in this chapter, move
the data into an Excel spreadsheet.
b. Using the data from step a, prepare a chart. Use
the Chart Wizard to properly label your axes.
2. In Web Exercise 1 you collected and graphed the Dow
Jones Industrial Average. Now go to www.forecasts
.org. Click on “Stock Market Forecast” and then on
“Dow Jones Industrial Average” in the left column.
Review the forecast in the graph.
a. What is the Dow forecast to be in six months?
b. What percentage increase is forecast for the next
six months?
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CHAPTER
2
Overview of the
Financial System
PREVIEW
Suppose that you want to start a business that
to those who have a shortage of funds (you). More
manufactures a recently invented low-cost robot that
realistically, when Apple invents a better iPad, it may
cleans the house (even does windows), mows the
require funds to bring it to market. Similarly, when a
lawn, and washes the car, but you have no funds to
local government needs to build a road or a school, it
put this wonderful invention into production. Walter
may need more funds than local property taxes pro-
has plenty of savings that he has inherited. If you
vide. Well-functioning financial markets and financial
and Walter could get together so that he could pro-
intermediaries are crucial to our economic health.
vide you with the funds, your company’s robot would
To study the effects of financial markets and
see the light of day, and you, Walter, and the econ-
financial intermediaries on the economy, we need to
omy would all be better off: Walter could earn a high
acquire an understanding of their general structure
return on his investment, you would get rich from
and operation. In this chapter we learn about the
producing the robot, and we would have cleaner
major financial intermediaries and the instruments
houses, shinier cars, and more beautiful lawns.
that are traded in financial markets.
Financial markets (bond and stock markets) and
This chapter offers a preliminary overview of the
financial intermediaries (banks, insurance companies,
fascinating study of financial markets and institu-
and pension funds) have the basic function of getting
tions. We will return to a more detailed treatment of
people such as you and Walter together by moving
the regulation, structure, and evolution of financial
funds from those who have a surplus of funds (Walter)
markets and institutions in Parts 3 through 7.
55
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Function of Financial Markets
Financial markets perform the essential economic function of channeling funds from
households, firms, and governments that have saved surplus funds by spending less
than their income to those that have a shortage of funds because they wish to spend
more than their income. This function is shown schematically in Figure 2.1. Those
who have saved and are lending funds, the lender-savers, are at the left and those
who must borrow funds to finance their spending, the borrower-spenders, are at the
right. The principal lender-savers are households, but business enterprises and
the government (particularly state and local government), as well as foreigners and
their governments, sometimes also find themselves with excess funds and so lend
them out. The most important borrower-spenders are businesses and the government (particularly the federal government), but households and foreigners also borrow to finance their purchases of cars, furniture, and houses. The arrows show that
funds flow from lender-savers to borrower-spenders via two routes.
In direct finance (the route at the bottom of Figure 2.1), borrowers borrow
funds directly from lenders in financial markets by selling them securities (also
called financial instruments), which are claims on the borrower’s future income
or assets. Securities are assets for the person who buys them, but they are liabilities
INDIRECT FINANCE
Financial
Intermediaries
FUNDS
FUNDS
FUNDS
Lender-Savers
1. Households
2. Business firms
3. Government
4. Foreigners
FUNDS
Financial
Markets
FUNDS
Borrower-Spenders
1. Business firms
2. Government
3. Households
4. Foreigners
DIRECT FINANCE
FIGURE 2.1 Flows of Funds Through the Financial System
The arrows show that funds flow from lender-savers to borrower-spenders via two routes: direct finance,
in which borrowers borrow funds directly from financial markets by selling securities, and indirect
finance, in which a financial intermediary borrows funds from lender-savers and then uses these funds
to make loans to borrower-spenders.
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Overview of the Financial System
57
(IOUs or debts) for the individual or firm that sells (issues) them. For example, if
General Motors needs to borrow funds to pay for a new factory to manufacture
electric cars, it might borrow the funds from savers by selling them a bond, a debt
security that promises to make payments periodically for a specified period of time,
or a stock, a security that entitles the owner to a share of the company’s profits and
assets.
Why is this channeling of funds from savers to spenders so important to the
economy? The answer is that the people who save are frequently not the same
people who have profitable investment opportunities available to them, the entrepreneurs. Let’s first think about this on a personal level. Suppose that you have
saved $1,000 this year, but no borrowing or lending is possible because no financial
markets are available. If you do not have an investment opportunity that will permit
you to earn income with your savings, you will just hold on to the $1,000 and will
earn no interest. However, Carl the carpenter has a productive use for your $1,000:
He can use it to purchase a new tool that will shorten the time it takes him to build
a house, thereby earning an extra $200 per year. If you could get in touch with Carl,
you could lend him the $1,000 at a rental fee (interest) of $100 per year, and both
of you would be better off. You would earn $100 per year on your $1,000, instead of
the zero amount that you would earn otherwise, while Carl would earn $100 more
income per year (the $200 extra earnings per year minus the $100 rental fee for the
use of the funds).
In the absence of financial markets, you and Carl the carpenter might never get
together. You would both be stuck with the status quo, and both of you would be
worse off. Without financial markets, it is hard to transfer funds from a person who
has no investment opportunities to one who has them. Financial markets are thus
essential to promoting economic efficiency.
The existence of financial markets is beneficial even if someone borrows for a
purpose other than increasing production in a business. Say that you are recently
married, have a good job, and want to buy a house. You earn a good salary, but
because you have just started to work, you have not saved much. Over time, you
would have no problem saving enough to buy the house of your dreams, but by then
you would be too old to get full enjoyment from it. Without financial markets, you
are stuck; you cannot buy the house and must continue to live in your tiny apartment.
If a financial market were set up so that people who had built up savings could
lend you the funds to buy the house, you would be more than happy to pay them
some interest so that you could own a home while you are still young enough to
enjoy it. Then, over time, you would pay back your loan. If this loan could occur, you
would be better off, as would the persons who made you the loan. They would now
earn some interest, whereas they would not if the financial market did not exist.
Now we can see why financial markets have such an important function in the
economy. They allow funds to move from people who lack productive investment
opportunities to people who have such opportunities. Financial markets are critical
for producing an efficient allocation of capital (wealth, either financial or physical,
that is employed to produce more wealth), which contributes to higher production
and efficiency for the overall economy. Indeed, as we will explore in Chapter 8,
when financial markets break down during financial crises, as they did during the
recent global financial crisis, severe economic hardship results, which can even lead
to dangerous political instability.
Well-functioning financial markets also directly improve the well-being of consumers by allowing them to time their purchases better. They provide funds to
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young people to buy what they need and can eventually afford without forcing them
to wait until they have saved up the entire purchase price. Financial markets that
are operating efficiently improve the economic welfare of everyone in the society.
Structure of Financial Markets
Now that we understand the basic function of financial markets, let’s look at their
structure. The following descriptions of several categorizations of financial markets
illustrate the essential features of these markets.
Debt and Equity Markets
A firm or an individual can obtain funds in a financial market in two ways. The most
common method is to issue a debt instrument, such as a bond or a mortgage, which
is a contractual agreement by the borrower to pay the holder of the instrument fixed
dollar amounts at regular intervals (interest and principal payments) until a specified date (the maturity date), when a final payment is made. The maturity of a debt
instrument is the number of years (term) until that instrument’s expiration date.
A debt instrument is short-term if its maturity is less than a year and long-term if
its maturity is 10 years or longer. Debt instruments with a maturity between one and
10 years are said to be intermediate-term.
The second method of raising funds is by issuing equities, such as common
stock, which are claims to share in the net income (income after expenses and
taxes) and the assets of a business. If you own one share of common stock in a
company that has issued one million shares, you are entitled to 1 one-millionth of
the firm’s net income and 1 one-millionth of the firm’s assets. Equities often make
periodic payments (dividends) to their holders and are considered long-term securities because they have no maturity date. In addition, owning stock means that you
own a portion of the firm and thus have the right to vote on issues important to the
firm and to elect its directors.
The main disadvantage of owning a corporation’s equities rather than its debt is
that an equity holder is a residual claimant; that is, the corporation must pay all
its debt holders before it pays its equity holders. The advantage of holding equities
is that equity holders benefit directly from any increases in the corporation’s profitability or asset value because equities confer ownership rights on the equity holders.
Debt holders do not share in this benefit because their dollar payments are fixed.
We examine the pros and cons of debt versus equity instruments in more detail in
Chapter 7, which provides an economic analysis of financial structure.
The total value of equities in the United States has typically fluctuated between
$15 trillion and $40 trillion since 2000, depending on the prices of shares. Although
the average person is more aware of the stock market than any other financial market, the size of the debt market is often substantially larger than the size of the
equities market: At the end of 2015, the value of debt instruments was $39.7 trillion,
while the value of equities was $25.1 trillion.
Primary and Secondary Markets
A primary market is a financial market in which new issues of a security, such as
a bond or a stock, are sold to initial buyers by the corporation or government agency
borrowing the funds. A secondary market is a financial market in which securities
that have been previously issued can be resold.
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CHAPTER 2
GO
ONLINE
www.nyse.com
Access the New York Stock
Exchange. Find listed companies, quotes, company historical data, real-time market
indexes, and more.
Overview of the Financial System
59
The primary markets for securities are not well known to the public because the
selling of securities to initial buyers often takes place behind closed doors. An
important financial institution that assists in the initial sale of securities in the primary market is the investment bank. It does this by underwriting securities: It
guarantees a price for a corporation’s securities and then sells them to the public.
The New York Stock Exchange and NASDAQ (National Association of Securities
Dealers Automated Quotation System), in which previously issued stocks are traded,
are the best-known examples of secondary markets, although the bond markets, in
which previously issued bonds of major corporations and the U.S. government are
bought and sold, actually have a larger trading volume. Other examples of secondary
markets are foreign exchange markets, futures markets, and options markets.
Securities brokers and dealers are crucial to a well-functioning secondary market.
Brokers are agents of investors who match buyers with sellers of securities; dealers
link buyers and sellers by buying and selling securities at stated prices.
When an individual buys a security in the secondary market, the person who has
sold the security receives money in exchange for the security, but the corporation
that issued the security acquires no new funds. A corporation acquires new funds
only when its securities are first sold in the primary market. Nonetheless, secondary
markets serve two important functions. First, they make it easier and quicker to sell
these financial instruments to raise cash; that is, they make the financial instruments more liquid. The increased liquidity of these instruments then makes them
more desirable and thus easier for the issuing firm to sell in the primary market.
Second, they determine the price of the security that the issuing firm sells in the
primary market. The investors who buy securities in the primary market will pay the
issuing corporation no more than the price they think the secondary market will set
for this security. The higher the security’s price in the secondary market, the higher
the price that the issuing firm will receive for a new security in the primary market,
and hence the greater the amount of financial capital it can raise. Conditions in the
secondary market are therefore the most relevant to corporations issuing securities.
For this reason books like this one, which deal with financial markets, focus on the
behavior of secondary markets rather than primary markets.
Exchanges and Over-the-Counter Markets
GO
ONLINE
www.nasdaq.com
Access detailed market
and security information
for the NASDAQ OTC stock
exchange.
Secondary markets can be organized in two ways. One method is to organize
exchanges, where buyers and sellers of securities (or their agents or brokers) meet
in one central location to conduct trades. The New York and American Stock
Exchanges for stocks and the Chicago Board of Trade for commodities (wheat, corn,
silver, and other raw materials) are examples of organized exchanges.
The other method of organizing a secondary market is to have an over-thecounter (OTC) market, in which dealers at different locations who have an inventory of securities stand ready to buy and sell securities “over the counter” to anyone
who comes to them and is willing to accept their prices. Because over-the-counter
dealers are in contact via computers and know the prices set by one another, the
OTC market is very competitive and not very different from a market with an organized exchange.
Many common stocks are traded over the counter, although a majority of the
largest corporations have their shares traded at organized stock exchanges. The
U.S. government bond market, with a larger trading volume than the New York
Stock Exchange, by contrast, is set up as an over-the-counter market. Forty or so
dealers establish a “market” in these securities by standing ready to buy and sell
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U.S. government bonds. Other over-the-counter markets include those that trade
other types of financial instruments such as negotiable certificates of deposit, federal funds, banker’s acceptances, and foreign exchange.
Money and Capital Markets
Another way of distinguishing between markets is on the basis of the maturity of the
securities traded in each market. The money market is a financial market in which
only short-term debt instruments (generally those with original maturity of less than
one year) are traded; the capital market is the market in which longer-term debt
(generally with original maturity of one year or greater) and equity instruments are
traded. Money market securities are usually more widely traded than longer-term
securities and so tend to be more liquid. In addition, as we will see in Chapter 3,
short-term securities have smaller fluctuations in prices than long-term securities,
making them safer investments. As a result, corporations and banks actively use the
money market to earn interest on surplus funds that they expect to have only temporarily. Capital market securities, such as stocks and long-term bonds, are often
held by financial intermediaries such as insurance companies and pension funds,
which have little uncertainty about the amount of funds they will have available in
the future.
Internationalization of Financial Markets
The growing internationalization of financial markets has become an important
trend. Before the 1980s, U.S. financial markets were much larger than those outside
the United States, but in recent years the dominance of U.S. markets has been disappearing. (See the Global box, “Are U.S. Capital Markets Losing Their Edge?”) The
extraordinary growth of foreign financial markets has been the result of both large
increases in the pool of savings in foreign countries such as Japan and the deregulation of foreign financial markets, which has enabled foreign markets to expand their
activities. American corporations and banks are now more likely to tap international
capital markets to raise needed funds, and American investors often seek investment opportunities abroad. Similarly, foreign corporations and banks raise funds
from Americans, and foreigners have become important investors in the United
States. A look at international bond markets and world stock markets will give us a
picture of how this globalization of financial markets is taking place.
International Bond Market, Eurobonds,
and Eurocurrencies
The traditional instruments in the international bond market are known as foreign
bonds. Foreign bonds are sold in a foreign country and are denominated in that
country’s currency. For example, if the German automaker Porsche sells a bond in
the United States denominated in U.S. dollars, it is classified as a foreign bond.
Foreign bonds have been an important instrument in the international capital market for centuries. In fact, a large percentage of U.S. railroads built in the nineteenth
century were financed by sales of foreign bonds in Britain.
A more recent innovation in the international bond market is the Eurobond, a
bond denominated in a currency other than that of the country in which it is
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GLOBAL
CHAPTER 2
Overview of the Financial System
61
Are U.S. Capital Markets Losing Their Edge?
Over the past few decades the United States lost its
international dominance in a number of manufacturing industries, including automobiles and consumer
electronics, as other countries became more competitive in global markets. Recent evidence suggests that
financial markets now are undergoing a similar trend:
Just as Ford and General Motors have lost global
market share to Toyota and Honda, U.S. stock and
bond markets recently have seen their share of sales
of newly issued corporate securities slip. The London
and Hong Kong stock exchanges now handle a larger
share of initial public offerings (IPOs) of stock than
does the New York Stock Exchange, which had been
by far the dominant exchange in terms of IPO value
before 2000. Furthermore, the number of stocks
listed on U.S. exchanges has been falling, while stock
listings abroad have been growing rapidly: Listings
outside the United States are now about ten times
greater than those in the United States. Likewise, the
portion of new corporate bonds issued worldwide that
are initially sold in U.S. capital markets has fallen
below the share sold in European debt markets.
Why do corporations that issue new securities to
raise capital now conduct more of this business in
financial markets in Europe and Asia than in the
United States? Among the factors contributing to this
trend are quicker adoption of technological innovation by foreign financial markets, tighter immigration
controls in the United States following the terrorist attacks in 2001, and perceptions that listing on
American exchanges will expose foreign securities
issuers to greater risks of lawsuits. Many people see
burdensome financial regulation as the main cause,
however, and point specifically to the Sarbanes-Oxley
Act of 2002. Congress passed this act after a number
of accounting scandals involving U.S. corporations
and the accounting firms that audited them came to
light. Sarbanes-Oxley aims to strengthen the integrity
of the auditing process and the quality of information
provided in corporate financial statements. The costs
to corporations of complying with the new rules and
procedures are high, especially for smaller firms, but
largely avoidable if firms choose to issue their securities in financial markets outside the United States.
For this reason, there is much support for revising
Sarbanes-Oxley to lessen its alleged harmful effects
and induce more securities issuers back to U.S. financial markets. However, evidence is not conclusive
to support the view that Sarbanes-Oxley is the main
cause of the relative decline of U.S. financial markets
and therefore in need of reform.
Discussion of the relative decline of U.S. financial
markets and debate about the factors that are contributing to it likely will continue. Chapter 7 provides
more detail on the Sarbanes-Oxley Act and its effects
on the U.S. financial system.
sold—for example, a bond denominated in U.S. dollars sold in London. Currently,
over 80% of the new issues in the international bond market are Eurobonds, and the
market for these securities has grown very rapidly. As a result, the Eurobond market
is now larger than the U.S. corporate bond market.
A variant of the Eurobond is Eurocurrencies, which are foreign currencies
deposited in banks outside the home country. The most important of the
Eurocurrencies are Eurodollars, which are U.S. dollars deposited in foreign banks
outside the United States or in foreign branches of U.S. banks. Because these shortterm deposits earn interest, they are similar to short-term Eurobonds. American
banks borrow Eurodollar deposits from other banks or from their own foreign
branches, and Eurodollars are now an important source of funds for American
banks. Note that the euro, the currency used by countries in the European Monetary
System, can create some confusion about the terms Eurobond, Eurocurrencies,
and Eurodollars. A bond denominated in euros is called a Eurobond only if it is
sold outside the countries that have adopted the euro. In fact, most Eurobonds
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are not denominated in euros but are instead denominated in U.S. dollars. Similarly,
Eurodollars have nothing to do with euros, but are instead U.S. dollars deposited in
banks outside the United States.
GO
ONLINE
www.stockcharts.com
This site contains historical
stock market index charts
for many countries around
the world.
GO
ONLINE
http://quote.yahoo.com/m2?u
Access major world stock
indexes, with charts, news,
and components.
World Stock Markets
Until recently, the U.S. stock market was by far the largest in the world, but foreign
stock markets have been growing in importance, with the United States not always
number one. The increased interest in foreign stocks has prompted the development in the United States of mutual funds that specialize in trading in foreign stock
markets. American investors now pay attention not only to the Dow Jones Industrial
Average but also to stock price indexes for foreign stock markets such as the Nikkei
300 Average (Tokyo) and the Financial Times Stock Exchange (FTSE) 100-Share
Index (London).
The internationalization of financial markets is having profound effects on the
United States. Foreigners, particularly Chinese investors, not only are providing
funds to corporations in the United States but also are helping finance the federal
government. Without these foreign funds, the U.S. economy would have grown far
less rapidly in the past 20 years. The internationalization of financial markets is also
leading the way to a more integrated world economy in which flows of goods and
technology between countries are more commonplace. In later chapters, we will
encounter many examples of the important roles that international factors play in
our economy (see the Following the Financial News box).
Function of Financial Intermediaries:
Indirect Finance
As shown in Figure 2.1 (p. 56), funds also can move from lenders to borrowers by a
second route called indirect finance because it involves a financial intermediary
that stands between the lender-savers and the borrower-spenders and helps transfer funds from one to the other. A financial intermediary does this by borrowing
funds from the lender-savers and then using these funds to make loans to borrowerspenders. For example, a bank might acquire funds by issuing a liability to the public (an asset for the public) in the form of savings deposits. It might then use the
funds to acquire an asset by making a loan to General Motors or by buying a U.S.
Treasury bond in the financial market. The ultimate result is that funds have been
transferred from the public (the lender-savers) to General Motors or the U.S.
Treasury (the borrower-spender) with the help of the financial intermediary (the
bank).
The process of indirect finance using financial intermediaries, called financial
intermediation, is the primary route for moving funds from lenders to borrowers.
Indeed, although the media focus much of their attention on securities markets,
particularly the stock market, financial intermediaries are a far more important
source of financing for corporations than securities markets are. This is true not
only for the United States but also for other industrialized countries (see the
Global box). Why are financial intermediaries and indirect finance so important in
financial markets? To answer this question, we need to understand the role of transaction costs, risk sharing, and information costs in financial markets.
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63
FOLLOWING THE FINANCIAL NEWS
Foreign Stock Market Indexes
Foreign stock market indexes are published daily in
newspapers and Internet sites such as www.finance
.yahoo.com.
The most important of these stock market indexes are:
Dow Jones Industrial Average (DJIA) An index of the
30 largest publicly traded corporations in the United
States maintained by the Dow Jones Corporation.
S&P 500 An index of 500 of the largest companies
traded in the United States maintained by Standard
& Poor’s.
GLOBAL
Nasdaq Composite An index for all the stocks that
trade on the Nasdaq stock market, where most
of the technology stocks in the United States are
traded.
FTSE 100 An index of the 100 most highly capitalized
UK companies listed on the London Stock Exchange.
DAX An index of the 30 largest German companies
trading on the Frankfurt Stock Exchange.
CAC 40 An index of the largest 40 French companies
traded on Euronext Paris.
Hang Seng An index of the largest companies traded
on the Hong Kong stock markets.
Strait Times An index of the largest 30 companies
traded on the Singapore Exchange.
The Importance of Financial Intermediaries Relative
to Securities Markets: An International Comparison
Patterns of financing corporations differ across countries, but one key fact emerges: Studies of the major
developed countries, including the United States,
Canada, the United Kingdom, Japan, Italy, Germany,
and France, show that when businesses go looking for
funds to finance their activities, they usually obtain
them indirectly through financial intermediaries and
not directly from securities markets.* Even in the United States and Canada, which have the most developed
securities markets in the world, loans from financial
intermediaries are far more important for corporate
finance than securities markets are. The countries
that have made the least use of securities markets are
Germany and Japan; in these two countries, financing from financial intermediaries has been almost
10 times greater than that from securities markets.
However, after the deregulation of Japanese securities
markets in recent years, the share of corporate financing by financial intermediaries has been declining
relative to the use of securities markets.
Although the dominance of financial intermediaries over securities markets is clear in all countries,
the relative importance of bond versus stock markets
differs widely across countries. In the United States
the bond market is far more important as a source
of corporate finance: On average, the amount of new
financing raised using bonds is 10 times the amount
raised using stocks. By contrast, countries such as
France and Italy make more use of equities markets
than of the bond market to raise capital.
* See, for example, Colin Mayer, “Financial Systems, Corporate Finance, and Economic Development,” in Asymmetric Information,
Corporate Finance, and Investment, ed. R. Glenn Hubbard (Chicago: University of Chicago Press, 1990), pp. 307–332.
Transaction Costs
Transaction costs, the time and money spent in carrying out financial transactions, are a major problem for people who have excess funds to lend. As we have
seen, Carl the carpenter needs $1,000 for his new tool, and you know that it is an
excellent investment opportunity. You have the cash and would like to lend him the
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money, but to protect your investment, you have to hire a lawyer to write up the
loan contract that specifies how much interest Carl will pay you, when he will make
these interest payments, and when he will repay you the $1,000. Obtaining the contract will cost you $500. When you figure in this transaction cost for making the loan,
you realize that you can’t earn enough from the deal (you spend $500 to make perhaps $100) and reluctantly tell Carl that he will have to look elsewhere.
This example illustrates that small savers like you or potential borrowers like
Carl might be frozen out of financial markets and thus be unable to benefit from
them. Can anyone come to the rescue? Financial intermediaries can.
Financial intermediaries can substantially reduce transaction costs because
they have developed expertise in lowering them and because their large size allows
them to take advantage of economies of scale, the reduction in transaction costs
per dollar of transactions as the size (scale) of transactions increases. For example,
a bank knows how to find a good lawyer to produce an airtight loan contract, and
this contract can be used over and over again in its loan transactions, thus lowering
the legal cost per transaction. Instead of a loan contract (which may not be all that
well written) costing $500, a bank can hire a topflight lawyer for $5,000 to draw up
an airtight loan contract that can be used for 2,000 loans at a cost of $2.50 per loan.
At a cost of $2.50 per loan, it now becomes profitable for the financial intermediary
to lend Carl the $1,000.
Because financial intermediaries are able to reduce transaction costs substantially, they make it possible for you to provide funds indirectly to people like Carl
with productive investment opportunities. In addition, a financial intermediary’s low
transaction costs mean that it can provide its customers with liquidity services,
services that make it easier for customers to conduct transactions. For example,
banks provide depositors with checking accounts that enable them to pay their bills
easily. In addition, depositors can earn interest on checking and savings accounts
and yet still convert them into goods and services whenever necessary.
Risk Sharing
Another benefit made possible by the low transaction costs of financial institutions
is that they can help reduce the exposure of investors to risk—that is, uncertainty
about the returns investors will earn on assets. Financial intermediaries do this
through the process known as risk sharing: They create and sell assets with risk
characteristics that people are comfortable with, and the intermediaries then use
the funds they acquire by selling these assets to purchase other assets that may
have far more risk. Low transaction costs allow financial intermediaries to share risk
at low cost, enabling them to earn a profit on the spread between the returns they
earn on risky assets and the payments they make on the assets they have sold. This
process of risk sharing is also sometimes referred to as asset transformation
because, in a sense, risky assets are turned into safer assets for investors.
Financial intermediaries also promote risk sharing by helping individuals to
diversify and thereby lower the amount of risk to which they are exposed.
Diversification entails investing in a collection (portfolio) of assets whose returns
do not always move together, with the result that overall risk is lower than for individual assets. (Diversification is just another name for the old adage, “You shouldn’t
put all your eggs in one basket.”) Low transaction costs allow financial intermediaries to do this by pooling a collection of assets into a new asset and then selling it to
individuals.
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Asymmetric Information: Adverse Selection
and Moral Hazard
The presence of transaction costs in financial markets explains, in part, why financial intermediaries and indirect finance play such an important role in financial markets. An additional reason is that in financial markets, one party often does not know
enough about the other party to make accurate decisions. This inequality is called
asymmetric information. For example, a borrower who takes out a loan usually
has better information about the potential returns and risks associated with the
investment projects for which the funds are earmarked than the lender does. Lack
of information creates problems in the financial system both before and after the
transaction is entered into.1
Adverse selection is the problem created by asymmetric information before
the transaction occurs. Adverse selection in financial markets occurs when the
potential borrowers who are the most likely to produce an undesirable (adverse)
outcome—the bad credit risks—are the ones who most actively seek out a loan and
are thus most likely to be selected. Because adverse selection makes it more likely
that loans might be made to bad credit risks, lenders may decide not to make any
loans even though good credit risks exist in the marketplace.
To understand why adverse selection occurs, suppose that you have two aunts
to whom you might make a loan—Aunt Louise and Aunt Sheila. Aunt Louise is a
conservative type who borrows only when she has an investment she is quite sure
will pay off. Aunt Sheila, by contrast, is an inveterate gambler who has just come
across a get-rich-quick scheme that will make her a millionaire if she can just borrow
$1,000 to invest in it. Unfortunately, as with most get-rich-quick schemes, the probability is high that the investment won’t pay off and that Aunt Sheila will lose the
$1,000.
Which of your aunts is more likely to call you to ask for a loan? Aunt Sheila, of
course, because she has so much to gain if the investment pays off. You, however,
would not want to make a loan to her because the probability is high that her investment will turn sour and she will be unable to pay you back.
If you knew both your aunts very well—that is, if your information were not
asymmetric—you wouldn’t have a problem because you would know that Aunt
Sheila is a bad risk and so you would not lend to her. Suppose, though, that you
don’t know your aunts well. You are more likely to lend to Aunt Sheila than to Aunt
Louise because Aunt Sheila would be hounding you for the loan. Because of the
possibility of adverse selection, you might decide not to lend to either of your aunts,
even though there are times when Aunt Louise, who is an excellent credit risk,
might need a loan for a worthwhile investment.
Moral hazard is the problem created by asymmetric information after the
transaction occurs. Moral hazard in financial markets is the risk (hazard) that the
borrower might engage in activities that are undesirable (immoral) from the lender’s point of view because they make it less likely that the loan will be paid back.
Because moral hazard lowers the probability that the loan will be repaid, lenders
may decide that they would rather not make a loan.
As an example of moral hazard, suppose that you made a $1,000 loan to another
relative, Uncle Melvin, who needs the money to purchase a computer so that he can
1
Asymmetric information and the adverse selection and moral hazard concepts are also crucial
problems for the insurance industry. See Chapter 21.
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set up a business typing students’ term papers. Once you have made the loan, however, Uncle Melvin is more likely to slip off to the track and play the horses. If he
bets on a 20-to-1 long shot and wins with your money, he is able to pay back your
$1,000 and live high off the hog with the remaining $19,000. But if he loses, as is
likely, you don’t get paid back, and all he has lost is his reputation as a reliable,
upstanding uncle. Uncle Melvin therefore has an incentive to go to the track
because his gains ($19,000) if he bets correctly are much greater than the cost to
him (his reputation) if he bets incorrectly. If you knew what Uncle Melvin was up
to, you would prevent him from going to the track, and he would not be able to
increase the moral hazard. However, because it is hard for you to keep informed
about his whereabouts—that is, because information is asymmetric—there is a
good chance that Uncle Melvin will go to the track and you will not get paid back.
The risk of moral hazard might therefore discourage you from making the $1,000
loan to Uncle Melvin, even if you were sure that you would be paid back if he used
it to set up his business.
The problems created by adverse selection and moral hazard are significant
impediments to well-functioning financial markets. Again, financial intermediaries
can alleviate these problems.
With financial intermediaries in the economy, small savers can provide their
funds to the financial markets by lending these funds to a trustworthy intermediary—
say, the Honest John Bank—which in turn lends the funds out either by making
loans or by buying securities such as stocks or bonds. Successful financial intermediaries have higher earnings on their investments than do small savers because they
are better equipped than individuals to screen out bad credit risks from good ones,
thereby reducing losses due to adverse selection. In addition, financial intermediaries have high earnings because they develop expertise in monitoring the parties they
lend to, thus reducing losses due to moral hazard. The result is that financial intermediaries can afford to pay lender-savers interest or provide substantial services
and still earn a profit.
As we have seen, financial intermediaries play an important role in the economy
because they provide liquidity services, promote risk sharing, and solve information
problems, thereby allowing small savers and borrowers to benefit from the existence
of financial markets. The success of financial intermediaries in performing this role is
evidenced by the fact that most Americans invest their savings with them and obtain
loans from them. Financial intermediaries play a key role in improving economic
efficiency because they help financial markets channel funds from lender-savers to
people with productive investment opportunities. Without a well-functioning set of
financial intermediaries, it is very hard for an economy to reach its full potential. We
will explore further the role of financial intermediaries in the economy in Parts 5
and 6.
Economies of Scope and Conflicts
of Interest
Another reason why financial intermediaries play such an important role in the
economy is that by providing multiple financial services to their customers, such as
offering them bank loans or selling their bonds for them, they can also achieve
economies of scope; that is, they can lower the cost of information production for
each service by applying one information resource to many different services. An
investment bank, for example, can evaluate how good a credit risk a corporation is
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when making a loan to the firm, which then helps the bank decide whether it would
be easy to sell the bonds of this corporation to the public.
Although the presence of economies of scope may substantially benefit financial
institutions, it also creates potential costs in terms of conflicts of interest.
Conflicts of interest are a type of moral hazard problem that arises when a person
or institution has multiple objectives (interests) and, as a result, has conflicts
between those objectives. Conflicts of interest are especially likely to occur when a
financial institution provides multiple services. The potentially competing interests
of those services may lead an individual or firm to conceal information or disseminate misleading information. We care about conflicts of interest because a substantial reduction in the quality of information in financial markets increases asymmetric
information problems and prevents financial markets from channeling funds into the
most productive investment opportunities. Consequently, the financial markets and
the economy become less efficient. We will discuss conflicts of interest in financial
markets in more detail in Parts 3 and 6.
Types of Financial Intermediaries
We have seen why financial intermediaries have such an important function in the
economy. Now we look at the principal financial intermediaries themselves and how
they perform the intermediation function. They fall into three categories: depository
institutions (banks), contractual savings institutions, and investment intermediaries. Table 2.1 provides a guide to the discussion of the financial intermediaries that
fit into these three categories by describing their primary liabilities (sources of
funds) and assets (uses of funds). The relative size of these intermediaries in the
United States is indicated in Table 2.2, which lists the amounts of their assets at the
end of 1990, 2000, 2010, and 2015.
Depository Institutions
Depository institutions (for simplicity, we refer to these as banks throughout this
text) are financial intermediaries that accept deposits from individuals and institutions and make loans. These institutions include commercial banks and the so-called
thrift institutions (thrifts): savings and loan associations, mutual savings banks,
and credit unions.
Commercial Banks These financial intermediaries raise funds primarily by issuing
checkable deposits (deposits on which checks can be written), savings deposits
(deposits that are payable on demand but do not allow their owner to write checks),
and time deposits (deposits with fixed terms to maturity). They then use these funds
to make commercial, consumer, and mortgage loans and to buy U.S. government
securities and municipal bonds. Around 5,000 commercial banks are found in the
United States, and as a group, they are the largest financial intermediary and have
the most diversified portfolios (collections) of assets.
Savings and Loan Associations (S&Ls) and Mutual Savings Banks These
depository institutions, of which there are approximately 900, obtain funds primarily
through savings deposits (often called shares) and time and checkable deposits.
In the past, these institutions were constrained in their activities and mostly made
mortgage loans for residential housing. Over time, these restrictions have been
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TABLE 2.1
P rimary Assets and Liabilities of Financial Intermediaries
Primary Liabilities
(Sources of Funds)
Primary Assets
(Uses of Funds)
Commercial banks
Deposits
Business and consumer
loans, mortgages, U.S.
government securities,
and municipal bonds
Savings and loan
associations
Deposits
Mortgages
Mutual savings banks
Deposits
Mortgages
Credit unions
Deposits
Consumer loans
Type of Intermediary
Depository institutions (banks)
Contractual savings institutions
Life insurance companies
Premiums from policies
Corporate bonds and
mortgages
Fire and casualty
insurance companies
Premiums from policies
Municipal bonds, corporate
bonds and stock, and U.S.
government securities
Pension funds,
government retirement
funds
Employer and employee
contributions
Corporate bonds and stock
Finance companies
Commercial paper, stocks,
bonds
Consumer and business
loans
Mutual funds
Shares
Stocks, bonds
Money market mutual
funds
Shares
Money market instruments
Hedge funds
Partnership participation
Stocks, bonds, loans,
foreign currencies, and
many other assets
Investment intermediaries
loosened so the distinction between these depository institutions and commercial
banks has blurred. These intermediaries have become more alike and are now more
competitive with each other.
Credit Unions These financial institutions, numbering about 7,000, are typically
very small cooperative lending institutions organized around a particular group:
union members, employees of a particular firm, and so forth. They acquire funds
from deposits called shares and primarily make consumer loans.
Contractual Savings Institutions
Contractual savings institutions, such as insurance companies and pension funds,
are financial intermediaries that acquire funds at periodic intervals on a contractual
basis. Because they can predict with reasonable accuracy how much they will have
to pay out in benefits in the coming years, they do not have to worry as much as
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TABLE 2.2
Overview of the Financial System
69
Principal Financial Intermediaries and Value of Their Assets
Value of Assets ($ billions, end of year)
Type of Intermediary
1990
2000
2010
2015
4,779
7,687
15,580
17,368
215
441
912
1,146
1,367
3,136
5,176
6,350
533
862
1,242
1,591
1,629
4,355
4,527
8,517
737
2,293
2,661
5,641
Finance companies
610
1,140
1,439
1,474
Mutual funds
654
4,435
7,935
12,843
Money market mutual funds
498
1,812
2,755
2,716
Depository institutions (banks)
Commercial banks, savings and loans,
and mutual savings banks
Credit unions
Contractual savings institutions
Life insurance companies
Fire and casualty insurance companies
Pension funds (private)
State and local government retirement
funds
Investment intermediaries
Source: Federal Reserve Flow of Funds Accounts: https://www.federalreserve.gov/releases/z1/current/data.htm,
Tables L110, L114, L115, L116, L118, L120, L121, L122, L127.
depository institutions about losing funds quickly. As a result, the liquidity of assets
is not as important a consideration for them as it is for depository institutions, and
they tend to invest their funds primarily in long-term securities such as corporate
bonds, stocks, and mortgages.
Life Insurance Companies Life insurance companies insure people against
financial hazards following a death and sell annuities (annual income payments upon
retirement). They acquire funds from the premiums that people pay to keep their
policies in force and use them mainly to buy corporate bonds and mortgages. They
also purchase stocks but are restricted in the amount that they can hold. Currently,
with $6.4 trillion in assets, they are among the largest of the contractual savings
institutions.
Fire and Casualty Insurance Companies These companies insure their
policyholders against loss from theft, fire, and accidents. They are very much like life
insurance companies, receiving funds through premiums for their policies, but they
have a greater possibility of loss of funds if major disasters occur. For this reason,
they use their funds to buy more liquid assets than life insurance companies do.
Their largest holding of assets consists of municipal bonds; they also hold corporate
bonds and stocks and U.S. government securities.
Pension Funds and Government Retirement Funds Private pension funds and
state and local retirement funds provide retirement income in the form of annuities to
employees who are covered by a pension plan. Funds are acquired by contributions
from employers and from employees, who either have a contribution automatically
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deducted from their paychecks or contribute voluntarily. The largest asset holdings
of pension funds are corporate bonds and stocks. The establishment of pension funds
has been actively encouraged by the federal government, both through legislation
requiring pension plans and through tax incentives to encourage contributions.
Investment Intermediaries
This category of financial intermediaries includes finance companies, mutual funds,
money market mutual funds, and investment banks.
Finance Companies Finance companies raise funds by selling commercial paper
(a short-term debt instrument) and by issuing stocks and bonds. They lend these
funds to consumers (who make purchases of such items as furniture, automobiles,
and home improvements) and to small businesses. Some finance companies are
organized by a parent corporation to help sell its product. For example, Ford Motor
Credit Company makes loans to consumers who purchase Ford automobiles.
Mutual Funds These financial intermediaries acquire funds by selling shares to
many individuals and use the proceeds to purchase diversified portfolios of stocks
and bonds. Mutual funds allow shareholders to pool their resources so that they
can take advantage of lower transaction costs when buying large blocks of stocks
or bonds. In addition, mutual funds allow shareholders to hold more diversified
portfolios than they otherwise would. Shareholders can sell (redeem) shares at any
time, but the value of these shares will be determined by the value of the mutual
fund’s holdings of securities. Because these fluctuate greatly, the value of mutual
fund shares does, too; therefore, investments in mutual funds can be risky.
Money Market Mutual Funds These financial institutions have the characteristics
of a mutual fund but also function to some extent as a depository institution because
they offer deposit-type accounts. Like most mutual funds, they sell shares to acquire
funds that are then used to buy money market instruments that are both safe and
very liquid. The interest on these assets is paid out to the shareholders.
A key feature of these funds is that shareholders can write checks against the
value of their shareholdings. In effect, shares in a money market mutual fund function like checking account deposits that pay interest. Money market mutual funds
have experienced extraordinary growth since 1971, when they first appeared. By
the end of 2015, their assets had climbed to nearly $2.7 trillion.
Hedge Funds Hedge funds are a type of mutual fund with special characteristics.
Hedge funds are organized as limited partnerships with minimum investments
ranging from $100,000 to, more typically, $1 million or more. These limitations mean
that hedge funds are subject to much weaker regulation than other mutual funds.
Hedge funds invest in many types of assets, with some specializing in stocks, others
in bonds, others in foreign currencies, and still others in far more exotic assets.
Investment Banks Despite its name, an investment bank is not a bank or a
financial intermediary in the ordinary sense; that is, it does not take in deposits and
then lend them out. Instead, an investment bank is a different type of intermediary
that helps a corporation issue securities. First it advises the corporation on which
type of securities to issue (stocks or bonds); then it helps sell (underwrite) the
securities by purchasing them from the corporation at a predetermined price and
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reselling them in the market. Investment banks also act as deal makers and earn
enormous fees by helping corporations acquire other companies through mergers
or acquisitions.
Regulation of the Financial System
GO
ONLINE
www.sec.gov
Access the United States
Securities and Exchange
Commission home page. It
contains vast SEC resources,
laws and regulations, investor
information, and litigation.
The financial system is among the most heavily regulated sectors of the American
economy. The government regulates financial markets for two main reasons: to
increase the information available to investors and to ensure the soundness of the
financial system. We will examine how these two reasons have led to the present
regulatory environment. As a study aid, the principal regulatory agencies of the U.S.
financial system are listed in Table 2.3.
TABLE 2.3
Principal Regulatory Agencies of the U.S. Financial System
Regulatory Agency
Subject of Regulation
Nature of Regulations
Securities and
Exchange
Commission (SEC)
Organized exchanges
and financial markets
Requires disclosure of
information; restricts insider
trading
Commodities Futures
Trading Commission
(CFTC)
Futures market
exchanges
Regulates procedures for trading
in futures markets
Office of the
Comptroller of the
Currency
Federally chartered
commercial banks and
thrift institutions
Charters and examines the
books of federally chartered
commercial banks and thrift
institutions; imposes restrictions
on assets they can hold
National Credit Union
Administration
(NCUA)
Federally chartered
credit unions
Charters and examines the books
of federally chartered credit
unions and imposes restrictions
on assets they can hold
State banking
and insurance
commissions
State-chartered
depository institutions
Charter and examine the books
of state-chartered banks and
insurance companies; impose
restrictions on assets they can
hold; and impose restrictions on
branching
Federal Deposit
Insurance
Corporation (FDIC)
Commercial banks,
mutual savings banks,
savings and loan
associations
Provides insurance of up to
$250,000 for each depositor
at a bank; examines the books
of insured banks; and imposes
restrictions on assets they can
hold
Federal Reserve
System
All depository
institutions
Examines the books of
commercial banks that are
members of the system; sets
reserve requirements for all
banks
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Increasing Information Available to Investors
Asymmetric information in financial markets means that investors may be subject to
adverse selection and moral hazard problems that may hinder the efficient operation
of financial markets. Risky firms or outright crooks may be the most eager to sell
securities to unwary investors, and the resulting adverse selection problem may
keep investors out of financial markets. Furthermore, once an investor has bought
a security, thereby lending money to a firm, the borrower may have incentives to
engage in risky activities or to commit outright fraud. The presence of this moral
hazard problem may also keep investors away from financial markets. Government
regulation can reduce adverse selection and moral hazard problems in financial markets and enhance the efficiency of the markets by increasing the amount of information available to investors.
As a result of the stock market crash in 1929 and revelations of widespread
fraud in the aftermath, political demands for regulation culminated in the Securities
Act of 1933 and the establishment of the Securities and Exchange Commission
(SEC). The SEC requires corporations issuing securities to disclose certain information about their sales, assets, and earnings to the public and restricts trading by the
largest stockholders (known as insiders) in the corporation. By requiring disclosure of this information and by discouraging insider trading, which could be used to
manipulate security prices, the SEC hopes that investors will be better informed and
protected from some of the abuses in financial markets that occurred before 1933.
Indeed, in recent years, the SEC has been particularly active in prosecuting people
involved in insider trading.
Ensuring the Soundness of Financial
Intermediaries
Asymmetric information can lead to the widespread collapse of financial intermediaries, referred to as a financial panic. Because providers of funds to financial intermediaries may not be able to assess whether the institutions holding their funds are
sound, if they have doubts about the overall health of financial intermediaries, they
may want to pull their funds out of both sound and unsound institutions. The possible outcome is a financial panic that produces large losses for the public and causes
serious damage to the economy. To protect the public and the economy from financial panics, the government has implemented six types of regulations.
Restrictions on Entry State banking and insurance commissions, as well as the
Office of the Comptroller of the Currency (an agency of the federal government),
have created tight regulations governing who is allowed to set up a financial
intermediary. Individuals or groups that want to establish a financial intermediary,
such as a bank or an insurance company, must obtain a charter from the state or the
federal government. Only if they appear to be upstanding citizens with impeccable
credentials and a large amount of initial funds will they be given a charter.
Disclosure Reporting requirements for financial intermediaries are stringent.
Their bookkeeping must follow certain strict principles, their books are subject to
periodic inspection, and they must make certain information available to the public.
Restrictions on Assets and Activities Financial intermediaries are restricted
in what they are allowed to do and what assets they can hold. Before you put funds
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into a bank or some other such institution, you would want to know that your funds
are safe and that the bank or other financial intermediary will be able to meet its
obligations to you. One way of doing this is to restrict the financial intermediary from
engaging in certain risky activities. Legislation passed in 1933 (repealed in 1999)
separated commercial banking from the securities industry so that banks could not
engage in risky ventures associated with this industry. Another way to limit a financial
intermediary’s risky behavior is to restrict it from holding certain risky assets, or
at least from holding a greater quantity of these risky assets than is prudent. For
example, commercial banks and other depository institutions are not allowed to hold
common stock because stock prices experience substantial fluctuations. Insurance
companies are allowed to hold common stock, but their holdings cannot exceed a
certain fraction of their total assets.
Deposit Insurance The government can insure people’s deposits so that they do
not suffer great financial loss if the financial intermediary that holds these deposits
should fail. The most important government agency that provides this type of
insurance is the Federal Deposit Insurance Corporation (FDIC), which insures each
depositor at a commercial bank, savings and loan association, or mutual savings bank
up to a loss of $250,000 per account. Premiums paid by these financial intermediaries
go into the FDIC’s Deposit Insurance Fund, which is used to pay off depositors if
an institution fails. The FDIC was created in 1934 after the massive bank failures of
1930–1933, in which the savings of many depositors at commercial banks were wiped
out. The National Credit Union Share Insurance Fund (NCUSIF) provides similar
insurance protection for deposits (shares) at credit unions.
Limits on Competition Politicians have often declared that unbridled competition
among financial intermediaries promotes failures that will harm the public. Although
the evidence that competition does indeed have this effect is extremely weak,
state and federal governments at times have imposed restrictions on the opening
of additional locations (branches). In the past, banks were not allowed to open
branches in other states, and in some states, banks were restricted from opening
branches in additional locations.
Restrictions on Interest Rates Competition has also been inhibited by regulations
that impose restrictions on interest rates that can be paid on deposits. For decades
after 1933, banks were prohibited from paying interest on checking accounts. In
addition, until 1986, the Federal Reserve System had the power under Regulation Q
to set maximum interest rates that banks could pay on savings deposits. These
regulations were instituted because of the widespread belief that unrestricted
interest-rate competition had contributed to bank failures during the Great
Depression. Later evidence does not seem to support this view, and Regulation Q
has been abolished (although there are still restrictions on paying interest on
checking accounts held by businesses).
In later chapters we will look more closely at government regulation of financial
markets and will see whether it has improved their functioning.
Financial Regulation Abroad
Not surprisingly, given the similarity of the economic system here and in Japan,
Canada, and the nations of western Europe, financial regulation in these countries
is similar to that in the United States. Provision of information is improved by
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requiring corporations issuing securities to report details about assets and liabilities,
earnings, and sales of stock, and by prohibiting insider trading. The soundness of
intermediaries is ensured by licensing, periodic inspection of financial intermediaries’ books, and provision of deposit insurance (although its coverage is smaller than
that in the United States and its existence is often intentionally not advertised).
The major differences between financial regulation in the United States and that
found abroad relate to bank regulation. In the past, the United States was the only
industrialized country to subject banks to restrictions on branching, which limited
their size and confined them to certain geographic regions. (These restrictions were
abolished by legislation in 1994.) U.S. banks are also the most restricted in the range
of assets they may hold. Banks abroad frequently hold shares in commercial firms;
in Japan and Germany, those stakes can be sizable.
SUMMARY
1. The basic function of financial markets is to channel funds from savers who have an excess of funds
to spenders who have a shortage of funds. Financial
markets can do this either through direct finance,
in which borrowers borrow funds directly from lenders by selling them securities, or through indirect
finance, which involves a financial intermediary that
stands between the lender-savers and the borrowerspenders and helps transfer funds from one to the
other. This channeling of funds improves the economic welfare of everyone in society. Because they
allow funds to move from people who have no productive investment opportunities to those who have
such opportunities, financial markets contribute to
economic efficiency. In addition, channeling of funds
directly benefits consumers by allowing them to
make purchases when they need them most.
2. Financial markets can be classified as debt and equity
markets, primary and secondary markets, exchanges
and over-the-counter markets, and money and capital
markets.
3. An important trend in recent years is the growing
internationalization of financial markets. Eurobonds,
which are denominated in a currency other than that
of the country in which they are sold, are now the
dominant security in the international bond market
and have surpassed U.S. corporate bonds as a source
of new funds. Eurodollars, which are U.S. dollars
deposited in foreign banks, are an important source
of funds for American banks.
4. Financial intermediaries are financial institutions that
acquire funds by issuing liabilities and, in turn, use
those funds to acquire assets by purchasing securities or making loans. Financial intermediaries play an
important role in the financial system because they
reduce transaction costs, allow risk sharing, and solve
problems created by adverse selection and moral hazard. As a result, financial intermediaries allow small
savers and borrowers to benefit from the existence of
financial markets, thereby increasing the efficiency of
the economy. However, the economies of scope that
help make financial intermediaries successful can
lead to conflicts of interest that make the financial
system less efficient.
5. The principal financial intermediaries fall into three
categories: (a) banks—commercial banks, savings
and loan associations, mutual savings banks, and
credit unions; (b) contractual savings institutions—
life insurance companies, fire and casualty insurance
companies, and pension funds; and (c) investment
intermediaries—finance companies, mutual funds,
money market mutual funds, hedge funds, and
investment banks.
6. The government regulates financial markets and
financial intermediaries for two main reasons: to
increase the information available to investors and
to ensure the soundness of the financial system.
Regulations include requiring disclosure of information to the public, restrictions on who can set up
a financial intermediary, restrictions on the assets
financial intermediaries can hold, the provision of
deposit insurance, limits on competition, and restrictions on interest rates.
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75
KEY TERMS
adverse selection, p. 65
asset transformation, p. 64
asymmetric information, p. 65
brokers, p. 59
capital, p. 57
capital market, p. 60
conflicts of interest, p. 67
dealers, p. 59
diversification, p. 64
dividends, p. 58
economies of scale, p. 64
economies of scope, p. 66
equities, p. 58
Eurobond, p. 60
Eurocurrencies, p. 61
Eurodollars, p. 61
exchanges, p. 59
financial intermediation, p. 62
financial panic, p. 72
foreign bonds, p. 60
intermediate-term, p. 58
investment bank, p. 59
liabilities, p. 56
liquid, p. 59
liquidity services, p. 64
long-term, p. 58
maturity, p. 58
money market, p. 60
moral hazard, p. 65
over-the-counter (OTC) market,
p. 59
portfolio, p. 64
primary market, p. 58
risk, p. 64
risk sharing, p. 64
secondary market, p. 58
short-term, p. 58
thrift institutions (thrifts), p. 67
transaction costs, p. 63
underwriting, p. 59
QUESTIONS
1. What is the main function of financial markets? Who
is usually better off in case of well-functioning markets? Explain your answer.
2. If I can buy a car today for $5,000 and it is worth
$10,000 in extra income next year to me because it
enables me to get a job as a traveling anvil seller,
should I take out a loan from Larry the loan shark at
a 90% interest rate if no one else will give me a loan?
Will I be better or worse off as a result of taking out
this loan? Can you make a case for legalizing loan
sharking?
3. Compare the performance of the emerging markets in Southeast Asia and the developed markets
in Western Europe in light of the recent global economic downturn.
4. In May 2017, the world’s first bond linked to the U.N.
Sustainable Development Goals (SDG) had been
issued by the World Bank, which helped it raise €163
million from investors in France and Italy and will be
used in projects aimed to eliminate extreme poverty.
Why do you think debt instruments are important?
5. How are Eurodollars similar to Eurobonds? How are
these related to Eurocurrencies?
6. What are the risks and rewards of investing in the
stock market as compared to the bond market?
7. Explain the problem of adverse selection created by
asymmetric flow of information. Use an example to
illustrate your answer.
8. Lisa is planning to purchase a new house and is
looking for a home loan that will give her the lowest interest rate. Discuss how she can be affected by
asymmetric information and adverse selection.
9. Why do loan sharks worry less bout moral hazard
in connection with their borrowers than some other
lenders do?
10. How does the presence of asymmetric information
in the direct selling market lead to consumers not
buying the products?
11. What is an adverse selection? How is it usually created in financial markets?
12. “Financial intermediaries play a crucial role in an
economic crisis–they are responsible for both causing the market to crash and then helping it recover
from the crisis.” Is this statement true? Discuss with
an example.
13. How do financial intermediaries solve the problem of
adverse selection?
14. What is a main function of investment banks? Do
such banks accept deposits and provide loans?
15. What is the main purpose of financial regulation?
What kind of instruments may a government use
to protect the economy and country from financial
panic?
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PART 1
Introduction
WEB EXERCISES
The Financial System
1. One of the best sources of information about financial
institutions is the U.S. Flow of Funds report produced
by the Federal Reserve. This document contains
data on most financial intermediaries. Go to www
.federalreserve.gov/releases/Z1/. Go to the most
current release. You may have to install Acrobat
Reader if your computer does not already have it;
the site has a link to download it for free. Go to the
Level Tables and answer the following questions.
a. What percentage of assets do commercial banks
hold in loans? What percentage of assets are held
in mortgage loans?
b. What percentage of assets do savings and loans
hold in mortgage loans?
c. What percentage of assets do credit unions hold in
mortgage loans and in consumer loans?
2. The most famous financial market in the world is the
New York Stock Exchange. Go to www.nyse.com.
a. What is the mission of the NYSE?
b. Firms must pay a fee to list their shares for sale on
the NYSE. What would be the fee for a firm with
5 million common shares outstanding?
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CHAPTER
PART 2 FUNDAMENTALS OF
FINANCIAL MARKET S
What Do Interest Rates Mean
and What Is Their Role in
Valuation?
PREVIEW
Interest rates are among the most closely watched
they use the term interest rate. We discuss how
variables in the economy. Their movements are
the yield to maturity is measured on credit market
reported almost daily by the news media because
instruments and how it is used to value these instru-
they directly affect our everyday lives and have
ments. We also see that a bond’s interest rate does
important consequences for the health of the econ-
not necessarily indicate how good an investment the
omy. They affect personal decisions such as whether
bond is because what it earns (its rate of return)
to consume or save, whether to buy a house, and
does not necessarily equal its interest rate. Finally,
whether to purchase bonds or put funds into a sav-
we explore the distinction between real interest
ings account. Interest rates also affect the economic
rates, which are adjusted for changes in the price
decisions of businesses and households, such as
level, and nominal interest rates, which are not.
whether to use their funds to invest in new equipment for factories or to save their money in a bank.
Before we can go on with the study of finan-
Although learning definitions is not always the
most exciting of pursuits, it is important to read
carefully and understand the concepts presented
cial markets, we must understand exactly what the
in this chapter. Not only are they continually used
phrase interest rates means. In this chapter, we see
throughout the remainder of this text, but a firm
that a concept known as the yield to maturity is the
grasp of these terms will give you a clearer under-
most accurate measure of interest rates; the yield
standing of the role that interest rates play in your
to maturity is what financial economists mean when
life as well as in the general economy.
77
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PART 2
Fundamentals of Financial Markets
Measuring Interest Rates
GO
ONLINE
www.bloomberg.com/
markets/
Under “Rates & Bonds,” you
can access information on key
interest rates, U.S. Treasuries, government bonds, and
municipal bonds.
Different debt instruments have very different streams of cash payments to the
holder (known as cash flows), with very different timing. Thus, we first need to
understand how we can compare the value of one kind of debt instrument with
another before we see how interest rates are measured. To do this, we use the concept of present value.
Present Value
The concept of present value (or present discounted value) is based on the
commonsense notion that a dollar of cash flow paid to you one year from now is less
valuable to you than a dollar paid to you today: This notion is true because you can
deposit a dollar in a savings account that earns interest and have more than a dollar
in one year. Economists use a more formal definition, as explained in this section.
Let’s look at the simplest kind of debt instrument, which we will call a simple
loan. In this loan, the lender provides the borrower with an amount of funds (called
the principal) that must be repaid to the lender at the maturity date, along with
an additional payment for the interest. For example, if you made your friend Jane a
simple loan of $100 for one year, you would require her to repay the principal of
$100 in one year’s time along with an additional payment for interest, say, $10. In
the case of a simple loan like this one, the interest payment divided by the amount
of the loan is a natural and sensible way to measure the interest rate. This measure
of the so-called simple interest rate, i, is
i =
$10
= 0.10 = 10%
$100
If you make this $100 loan, at the end of the year you would have $110, which
can be rewritten as:
$100 * 11 + 0.102 = $110
If you then lent out the $110, at the end of the second year you would have:
$110 * 11 + 0.102 = $121
or, equivalently,
$100 * 11 + 0.102 * 11 + 0.102 = $100 * 11 + 0.102 2 = $121
Continuing with the loan again, at the end of the third year you would have:
$121 * 11 + 0.102 = $100 * 11 + 0.102 3 = $133
Generalizing, we can see that at the end of n years, your $100 would turn into:
$100 * 11 + i2 n
The amounts you would have at the end of each year by making the $100 loan today
can be seen in the following timeline:
Today
0
Year
1
Year
2
Year
3
Year
n
$100
$110
$121
$133
$100 3 (1 1 0.10)n
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This timeline immediately tells you that you are just as happy having $100 today
as having $110 a year from now (of course, as long as you are sure that Jane will pay
you back). Or that you are just as happy having $100 today as having $121 two years
from now, or $133 three years from now, or $100 * 11 + 0.102 n in n years from
now. The timeline tells us that we can also work backward from future amounts to
the present. For example, $133 = $100 * 11 + 0.102 3 three years from now is
worth $100 today, so that:
$100 =
$133
11 + 0.102 3
The process of calculating today’s value of dollars received in the future, as we
have done above, is called discounting the future. We can generalize this process by
writing today’s (present) value of $100 as PV, writing the future cash flow of $133 as
CF, and replacing 0.10 (the 10% interest rate) by i. This leads to the following formula:
PV =
CF
(1 + i)n
(1)
Intuitively, what Equation 1 tells us is that if you are promised $1 of cash flow for
certain 10 years from now, this dollar would not be as valuable to you as $1 is today
because if you had the $1 today, you could invest it and end up with more than $1 in
10 years.
EXAMPLE 3.1
Simple Present
Value
What is the present value of $250 to be paid in two years if the interest rate is 15%?
Solution
The present value would be $189.04. Using Equation 1:
PV =
where
CF
(1 + i)n
CF = cash flow in two years = $250
i
= annual interest rate
= 0.15
n
= number of years
= 2
Thus,
PV =
Today
0
$250
$250
=
= $189.04
2
1.3225
(1 + 0.15)
Year
1
Year
2
$250
$189.04
The concept of present value is extremely useful because it enables us to figure
out today’s value of a credit market instrument at a given simple interest rate i by
just adding up the present value of all the future cash flows received. The present
value concept allows us to compare the value of two instruments with very different
timing of their cash flows.
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Fundamentals of Financial Markets
Four Types of Credit Market Instruments
In terms of the timing of their cash flows, there are four basic types of credit market
instruments.
1. A simple loan, which we have already discussed, in which the lender provides
the borrower with an amount of funds, which must be repaid to the lender
at the maturity date along with an additional payment for the interest. Many
money market instruments are of this type, for example, commercial loans
to businesses.
2. A fixed-payment loan (also called a fully amortized loan), in which the
lender provides the borrower with an amount of funds, which must be repaid
by making the same payment every period (such as a month), consisting of
part of the principal and interest for a set number of years. For example, if
you borrowed $1,000, a fixed-payment loan might require you to pay $126
every year for 25 years. Installment loans (such as auto loans) and mortgages
are frequently of the fixed-payment type.
3. A coupon bond pays the owner of the bond a fixed interest payment (coupon
payment) every year until the maturity date, when a specified final amount
(face value or par value) is repaid. The coupon payment is so named
because the bondholder used to obtain payment by clipping a coupon off
the bond and sending it to the bond issuer, who then sent the payment to
the holder. On all but the oldest bonds, it is no longer necessary to send in
coupons to receive these payments. A coupon bond with $1,000 face value,
for example, might pay you a coupon payment of $100 per year for 10 years,
and at the maturity date repay you the face value amount of $1,000. (The
face value of a bond is usually in $1,000 increments.)
A coupon bond is identified by three pieces of information. First is the corporation or government agency that issues the bond. Second is the maturity
date of the bond. Third is the bond’s coupon rate, the dollar amount of the
yearly coupon payment expressed as a percentage of the face value of the
bond. In our example, the coupon bond has a yearly coupon payment of $100
and a face value of $1,000. The coupon rate is then $100/$1,000 = 0.10, or
10%. Capital market instruments such as U.S. Treasury bonds and notes and
corporate bonds are examples of coupon bonds.
4. A discount bond (also called a zero-coupon bond) is bought at a price
below its face value (at a discount), and the face value is repaid at the maturity date. Unlike a coupon bond, a discount bond does not make any interest
payments; it just pays off the face value. For example, a discount bond with
a face value of $1,000 might be bought for $900; in a year’s time the owner
would be repaid the face value of $1,000. U.S. Treasury bills, U.S. savings
bonds, and long-term zero-coupon bonds are examples of discount bonds.
These four types of instruments require payments at different times: Simple
loans and discount bonds make payment only at their maturity dates, whereas fixedpayment loans and coupon bonds have payments periodically until maturity. How
would you decide which of these instruments would provide you with more income?
They all seem so different because they make payments at different times. To solve
this problem, we use the concept of present value, explained earlier, to provide us
with a procedure for measuring interest rates on these types of instruments.
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81
Yield to Maturity
Of the several common ways of calculating interest rates, the most important is the
yield to maturity, the interest rate that equates the present value of cash flows
received from a debt instrument with its value today. Because the concept behind
the calculation of the yield to maturity makes good economic sense, financial economists consider it the most accurate measure of interest rates.
To understand the yield to maturity better, we now look at how it is calculated
for the four types of credit market instruments. The key in all these examples to
understanding the calculation of the yield to maturity is equating today’s value of
the debt instrument with the present value of all of its future cash flow payments.
Simple Loan With the concept of present value, the yield to maturity on a simple
loan is easy to calculate. For the one-year loan we discussed, today’s value is $100,
and the cash flow in one year’s time would be $110 (the repayment of $100 plus the
interest payment of $10). We can use this information and Equation 1 to solve for
the yield to maturity i by recognizing that the present value of the future payments
must equal today’s value of a loan.
EXAMPLE 3.2
Simple Loan
If Pete borrows $100 from his sister and next year she wants $110 back from him, what
is the yield to maturity on this loan?
Solution
The yield to maturity on the loan is 10%.
PV =
CF
(1 + i)n
where
PV = amount borrowed
= $100
CF = cash flow in one year = $110
n
= number of years
= 1
Thus,
$100 =
$110
(1 + i)
(1 + i)$100 = $110
$110
$100
i = 1.10 - 1 = 0.10 = 10,
(1 + i) =
Year
1
Today
0
$100
i 5 10%
$110
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This calculation of the yield to maturity should look familiar because it equals
the interest payment of $10 divided by the loan amount of $100; that is, it equals the
simple interest rate on the loan. An important point to recognize is that for simple
loans, the simple interest rate equals the yield to maturity. Hence the same
term i is used to denote both the yield to maturity and the simple interest rate.
Fixed-Payment Loan Recall that this type of loan has the same cash flow payment
every year throughout the life of the loan. On a fixed-rate mortgage, for example,
the borrower makes the same payment to the bank every month until the maturity
date, when the loan will be completely paid off. To calculate the yield to maturity for
a fixed-payment loan, we follow the same strategy we used for the simple loan—we
equate today’s value of the loan with its present value. Because the fixed-payment
loan involves more than one cash flow payment, the present value of the fixedpayment loan is calculated as the sum of the present values of all cash flows (using
Equation 1).
Suppose the loan is $1,000 and the yearly cash flow payment is $85.81 for the
next 25 years. The present value is calculated as follows: At the end of one year,
there is a $85.81 cash flow payment with a PV of $85.81>11 + i2; at the end of two
years, there is another $85.81 cash flow payment with a PV of $85.81>11 + i2 2; and
so on until at the end of the 25th year, the last cash flow payment of $85.81 with a
PV of $85.81>11 + i2 25 is made. Making today’s value of the loan ($1,000) equal to
the sum of the present values of all the yearly cash flows gives us
$1,000 =
$85.81
$85.81
$85.81
$85.81
+
+
+ g +
2
3
1 + i
(1 + i)
(1 + i)
(1 + i)25
More generally, for any fixed-payment loan,
LV =
where
FP
FP
FP
FP
+
+
+ g +
1 + i (1 + i)2
(1 + i)n
(1 + i)3
(2)
LV = loan value
FP = fixed yearly cash flow payment
n = number of years until maturity
For a fixed-payment loan amount, the fixed yearly payment and the number of
years until maturity are known quantities, and only the yield to maturity is not. So
we can solve this equation for the yield to maturity i. Because this calculation is not
easy, many pocket calculators have programs that allow you to find i given the loan’s
numbers for LV, FP, and n. For example, in the case of the 25-year loan with yearly
payments of $85.81, the yield to maturity that solves Equation 2 is 7%. Real estate
brokers always have a pocket calculator or an app that can solve such equations so
that they can immediately tell the prospective house buyer exactly what the yearly
(or monthly) payments will be if the house purchase is financed by a mortgage.
EXAMPLE 3.3
Fixed-Payment
Loan
You decide to purchase a new home and need a $100,000 mortgage. You take out a
loan from the bank that has an interest rate of 7%. What is the yearly payment to the
bank to pay off the loan in 20 years?
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Solution
The yearly payment to the bank is $9,439.29.
LV =
FP
FP
FP
FP
+
+
+ g +
2
3
1 + i
(1
+ i)n
(1 + i)
(1 + i)
where
LV = loan value amount
= $100,000
i
= annual interest rate = 0.07
n
= number of years
= 20
Thus,
$100,000 =
FP
FP
FP
FP
+
+
+ g +
1 + 0.07 (1 + 0.07)2
(1 + 0.07)3
(1 + 0.07)20
To find the yearly payment for the loan using a financial calculator:
n
= number of years
PV = amount of the loan (LV)
= 20
= -100,000
FV = amount of the loan after 20 years = 0
i
= annual interest rate
= .07
Then push the PMT button = fixed yearly payment (FP) = $9,439.29.
Coupon Bond To calculate the yield to maturity for a coupon bond, follow the
same strategy used for the fixed-payment loan: Equate today’s value of the bond
with its present value. Because coupon bonds also have more than one cash flow
payment, the present value of the bond is calculated as the sum of the present values
of all the coupon payments plus the present value of the final payment of the face
value of the bond.
The present value of a $1,000 face value bond with 10 years to maturity and
yearly coupon payments of $100 (a 10% coupon rate) can be calculated as follows:
At the end of one year, there is a $100 coupon payment with a PV of $100>11 + i2;
at the end of two years, there is another $100 coupon payment with a PV of
$100>11 + i2 2; and so on until at maturity, there is a $100 coupon payment with a
PV of $100>11 + i2 10 plus the repayment of the $1,000 face value with a PV of
$1,000>11 + i2 10. Setting today’s value of the bond (its current price, denoted by P)
equal to the sum of the present values of all the cash flows for this bond gives
P =
$1,000
$100
$100
$100
$100
+
+
+ g +
+
2
3
10
(1 + i)
(1 + i)
(1 + i)
(1 + i)
(1 + i)10
More generally, for any coupon bond,1
P =
C
C
C
C
F
+
+
+ g +
n +
2
3
(1 + i) (1 + i)
(1 + i)
(1 + i)n
(1 + i)
(3)
1
Most coupon bonds actually make coupon payments on a semiannual basis rather than once a year as
assumed here. The effect on the calculations is only very slight and is ignored here.
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PART 2
Fundamentals of Financial Markets
where
P
C
F
n
=
=
=
=
price of coupon bond
yearly coupon payment
face value of the bond
years to maturity date
In Equation 3, the coupon payment, the face value, the years to maturity, and
the price of the bond are known quantities, and only the yield to maturity is not.
Hence we can solve this equation for the yield to maturity i.2 As in the case of the
fixed-payment loan, this calculation is not easy, so business-oriented software and
calculators have built-in programs that solve this equation for you.
EXAMPLE 3.4
Coupon Bond
Find the price of a 10% coupon bond with a face value of $1,000, a 12.25% yield to
maturity, and eight years to maturity.
Solution
The price of the bond is $889.20. To solve using a financial calculator,
n
= years to maturity
= 8
FV
= face value of the bond
= 1,000
i
= annual interest rate
= 12.25%
PMT = yearly coupon payments = 100
Then push the PV button = price of the bond = $889.20.
Table 3.1 shows the yields to maturity calculated for several bond prices. Three
interesting facts emerge:
1. When the coupon bond is priced at its face value, the yield to maturity equals
the coupon rate.
2. The price of a coupon bond and the yield to maturity are negatively related;
that is, as the yield to maturity rises, the price of the bond falls. If the yield
to maturity falls, the price of the bond rises.
3. The yield to maturity is greater than the coupon rate when the bond price is
below its face value.
TABLE 3.1 Y
ields to Maturity on a 10% Coupon Rate Bond Maturing in 10 Years
(Face Value = $1,000)
Price of Bond ($)
Yield to Maturity (%)
1,200
7.13
1,100
8.48
1,000
10.00
900
11.75
800
13.81
2
In other contexts, it is also called the internal rate of return.
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CHAPTER 3
GO
ONLINE
www.teachmefinance.com
Access a review of the key
financial concepts: time value
of money, annuities, perpetuities, and so on.
What Do Interest Rates Mean and What Is Their Role in Valuation?
85
These three facts are true for any coupon bond and are really not surprising if you
think about the reasoning behind the calculation of the yield to maturity. When you
put $1,000 in a bank account with an interest rate of 10%, you can take out $100 every
year and you will be left with the $1,000 at the end of 10 years. This process is similar
to buying the $1,000 bond with a 10% coupon rate analyzed in Table 3.1, which pays
a $100 coupon payment every year and then repays $1,000 at the end of 10 years. If
the bond is purchased at the par value of $1,000, its yield to maturity must equal the
interest rate of 10%, which is also equal to the coupon rate of 10%. The same reasoning applied to any coupon bond demonstrates that if the coupon bond is purchased at
its par value, the yield to maturity and the coupon rate must be equal.
It is straightforward to show that the valuation of a bond and the yield to maturity are negatively related. As i, the yield to maturity, rises, all denominators in the
bond price formula must necessarily rise. Hence a rise in the interest rate as measured by the yield to maturity means that the value and therefore the price of the
bond must fall. Another way to explain why the bond price falls when the interest
rate rises is that a higher interest rate implies that the future coupon payments and
final payment are worth less when discounted back to the present; hence the price
of the bond must be lower.
The third fact, that the yield to maturity is greater than the coupon rate when
the bond price is below its par value, follows directly from facts 1 and 2. When the
yield to maturity equals the coupon rate, then the bond price is at the face value;
when the yield to maturity rises above the coupon rate, the bond price necessarily
falls and so must be below the face value of the bond.
One special case of a coupon bond that is worth discussing because its yield to
maturity is particularly easy to calculate is called a perpetuity, or a consol; it is a
perpetual bond with no maturity date and no repayment of principal that makes
fixed coupon payments of $C forever. The formula in Equation 3 for the price of a
perpetuity, Pc, simplifies to the following:3
Pc =
where
C
ic
(4)
Pc = price of the perpetuity (consol)
C = yearly payment
ic = yield to maturity of the perpetuity (consol)
3
The bond price formula for a perpetuity is
Pc =
C
C
C
+
+
+ g
1 + ic
(1 + ic)2
(1 + ic)3
which can be written
Pc = C(x + x 2 + x 3 + g )
in which x = 1>(1 + i). From your high school algebra you might remember the formula for an infinite sum:
1
1 + x + x2 + x3 + g =
for x 6 1
1 - x
and so
1
1
- 1b = C c
- 1d
Pc = C a
1 - x
1 - 1>(1 + ic)
which by suitable algebraic manipulation becomes
Pc = C a
1 + ic
ic
-
ic
ic
b =
C
ic
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One nice feature of perpetuities is that you can immediately see that as ic goes
up, the price of the bond falls. For example, if a perpetuity pays $100 per year forever and the interest rate is 10%, its price will be $1,000 = $100/0.10. If the interest
rate rises to 20%, its price will fall to $500 = $100/0.20. We can also rewrite this
formula as
C
Pc
ic =
(5)
EXAMPLE 3.5
Perpetuity
What is the yield to maturity on a bond that has a price of $2,000 and pays $100
annually forever?
Solution
The yield to maturity would be 5%.
ic =
C
Pc
where
C = yearly payment
= $100
Pc = price of perpetuity (consol) = $2,000
Thus,
ic =
$100
$2,000
ic = 0.05 = 5,
The formula in Equation 5, which describes the calculation of the yield to maturity for a perpetuity, also provides a useful approximation for the yield to maturity
on coupon bonds. When a coupon bond has a long term to maturity (say, 20 years
or more), it is very much like a perpetuity, which pays coupon payments forever.
This is because the cash flows more than 20 years in the future have such small
present discounted values that the value of a long-term coupon bond is very close
to the value of a perpetuity with the same coupon rate. Thus, ic in Equation 5 will
be very close to the yield to maturity for any long-term bond. For this reason, ic, the
yearly coupon payment divided by the price of the security, has been given the
name current yield and is frequently used as an approximation to describe interest
rates (yields to maturity) on long-term bonds.
Discount Bond The yield-to-maturity calculation for a discount bond is similar
to that for the simple loan. Let’s consider a discount bond such as a one-year U.S.
Treasury bill, which pays a face value of $1,000 in one year’s time. If the current
purchase price of this bill is $900, then equating this price to the present value of
the $1,000 received in one year, using Equation 1, gives
$900 =
$1,000
1 + i
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and solving for i,
(1 + i) * $900 = $1,000
$900 + $900i = $1,000
$900i = $1,000 - $900
i =
$1,000 - $900
= 0.111 = 11.1,
$900
More generally, for any one-year discount bond, the yield to maturity can be written as
i =
where
F - P
P
(6)
F = face value of the discount bond
P = current price of the discount bond
GLOBAL
In other words, the yield to maturity equals the increase in price over the year
F - P divided by the initial price P. In normal circumstances, investors earn positive
returns from holding these securities and so they sell at a discount, meaning that
the current price of the bond is below the face value. Therefore, F - P should be
positive, and the yield to maturity should be positive as well. However, this is not
always the case, as extraordinary events in Japan and elsewhere have indicated (see
the Global box).
An important feature of this equation is that it indicates that for a discount
bond, the yield to maturity is negatively related to the current bond price. This is
Negative Interest Rates? Japan First, Then the
United States, Then Europe
We normally assume that the yield to maturity must
always be positive. A negative yield to maturity would
imply that you are willing to pay more for a bond today
than you will receive for it in the future (as our formula
for yield to maturity on a discount bond demonstrates).
A negative yield to maturity therefore seems like an
impossibility because you would do better by holding
cash that has the same value in the future as it does
today.
Events in Japan in the late 1990s and then in the
United States during the 2008 global financial crisis
and finally in Europe in recent years have demonstrated that this reasoning is not quite correct. In
November 1998, the yield to maturity on Japanese sixmonth Treasury bills became negative, at -0.004%. In
September 2008, the yield to maturity on three-month
U.S. T-bills fell very slightly below zero for a very brief
period. Interest rates that banks are paid on depos-
its they keep at their central banks became negative
first in Sweden in July 2009, followed by Denmark in
July 2012, the Eurozone in June 2014, Switzerland
in December 2014, and Japan in January 2016.
Negative interest rates have rarely occurred in the
past. How could this happen in recent years?
As we will see in Chapter 4, a dearth of investment opportunities and very low inflation can drive
interest rates to low levels, but these two factors
can’t explain the negative yield to maturity. The
answer is that despite negative interest rates, large
investors and banks found it more convenient to hold
Treasury bills or keep their funds as deposits at the
central bank because they are stored electronically.
For that reason, investors and banks were willing to
accept negative interest rates, even though in pure
monetary terms the investors would be better off
holding cash.
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the same conclusion that we reached for a coupon bond. For example, Equation 6
shows that a rise in the bond price from $900 to $950 means that the bond will have
a smaller increase in its price over its lifetime, and the yield to maturity falls from
11.1% to 5.3%. Similarly, a fall in the yield to maturity means that the price of the
discount bond has risen.
Summary The concept of present value tells you that a dollar in the future is not
as valuable to you as a dollar today because you can earn interest on this dollar.
Specifically, a dollar received n years from now is worth only $1>11 + i2 n today.
The present value of a set of future cash flows on a debt instrument equals the sum
of the present values of each of the future cash flows. The yield to maturity for an
instrument is the interest rate that equates the present value of the future cash flows
on that instrument to its value today. Because the procedure for calculating the yield
to maturity is based on sound economic principles, this is the measure that financial
economists think most accurately describes the interest rate.
Our calculations of the yield to maturity for a variety of bonds reveal the important fact that current bond prices and interest rates are negatively related:
When the interest rate rises, the price of the bond falls, and vice versa.
The Distinction Between Real and Nominal
Interest Rates
So far in our discussion of interest rates, we have ignored the effects of inflation on
the cost of borrowing. What we have up to now been calling the interest rate makes
no allowance for inflation, and it is more precisely referred to as the nominal interest
rate. We distinguish it from the real interest rate, the interest rate that is adjusted
by subtracting expected changes in the price level (inflation) so that it more accurately reflects the true cost of borrowing. This interest rate is more precisely referred
to as the ex ante real interest rate because it is adjusted for expected changes in
the price level. The ex ante real interest rate is most important to economic decisions, and typically it is what financial economists mean when they make reference
to the “real” interest rate. The interest rate that is adjusted for actual changes in
the price level is called the ex post real interest rate. It describes how well a lender
has done in real terms after the fact.
The real interest rate is more accurately defined by the Fisher equation, named
for Irving Fisher, one of the great monetary economists of the twentieth century.
The Fisher equation states that the nominal interest rate i equals the real interest
rate ir plus the expected rate of inflation πe.4
i = ir + πe
(7)
4
A more precise formulation of the Fisher equation is
i = ir + πe + (ir * πe)
because
1 + i = (1 + ir) (1 + πe) = 1 + ir + πe + (ir * πe)
and subtracting 1 from both sides gives us the first equation. For small values of ir and πe, the term
ir * πe is so small that we ignore it.
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Rearranging terms, we find that the real interest rate equals the nominal interest rate minus the expected inflation rate:
ir = i - πe
(8)
To see why this definition makes sense, let us first consider a situation in which
you have made a one-year simple loan with a 5% interest rate (i = 5%) and you
expect the price level to rise by 3% over the course of the year (πe = 3%). As a
result of making the loan, at the end of the year you expect to have 2% more in real
terms, that is, in terms of real goods and services you can buy.
In this case, the interest rate you expect to earn in terms of real goods and
services is 2%; that is,
ir = 5% - 3% = 2%
as indicated by the Fisher definition.
EXAMPLE 3.6
Real and
Nominal
Interest Rates
What is the real interest rate if the nominal interest rate is 8% and the expected inflation rate is 10% over the course of a year?
Solution
The real interest rate is –2%. Although you will be receiving 8% more dollars at the end
of the year, you will be paying 10% more for goods. The result is that you will be able to
buy 2% fewer goods at the end of the year, and you will be 2% worse off in real terms.
ir = i - πe
where
= nominal interest rate
i
= 0.08
e
π = expected inflation rate = 0.10
Thus,
ir = 0.08 - 0.10 = -0.02 = -2%
As a lender, you are clearly less eager to make a loan in Example 3.6 because in
terms of real goods and services you have actually earned a negative interest rate of
2%. By contrast, as the borrower, you fare quite well because at the end of the year,
the amounts you will have to pay back will be worth 2% less in terms of goods and
services—you as the borrower will be ahead by 2% in real terms. When the real
interest rate is low, there are greater incentives to borrow and fewer
incentives to lend.
The distinction between real and nominal interest rates is important because
the real interest rate, which reflects the real cost of borrowing, is likely to be a better indicator of the incentives to borrow and lend. It appears to be a better guide to
how people will be affected by what is happening in credit markets. Figure 3.1,
which presents estimates from 1953 to 2016 of the real and nominal interest rates
on three-month U.S. Treasury bills, shows us that nominal and real rates often do
not move together. (This is also true for nominal and real interest rates in the rest
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Interest
Rate (%)
16
12
8
Nominal Rate
4
0
Estimated Real Rate
–4
–8
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
FIGURE 3.1 Real and Nominal Interest Rates (Three-Month Treasury Bill), 1953–2016
Nominal and real interest rates often do not move together. When U.S. nominal rates were high in
the 1970s, real rates were actually extremely low—often negative.
Sources: Federal Reserve Bank of St. Louis FRED database: https://fred.stlouisfed.org/series/TB3MS and https://fred.stlouisfed.org/
series/CPIAUCSL. The real rate is constructed using the procedure outlined in Frederic S. Mishkin, “The Real Interest Rate: An
Empirical Investigation,” Carnegie–Rochester Conference Series on Public Policy 15 (1981): 151–200. This involves estimating
expected inflation as a function of past interest rates, inflation, and time trends and then subtracting the expected inflation measure
from the nominal interest rate.
of the world.) In particular, when nominal rates in the United States were high in
the 1970s, real rates were actually extremely low, often negative. By the standard of
nominal interest rates, you would have thought that credit market conditions were
tight in this period because it was expensive to borrow. However, the estimates of
the real rates indicate that you would have been mistaken. In real terms, the cost of
borrowing was actually quite low.5
5
Because most interest income in the United States is subject to federal income taxes, the true earnings in real terms from holding a debt instrument are not reflected by the real interest rate defined by
the Fisher equation but rather by the after-tax real interest rate, which equals the nominal interest
rate after income tax payments have been subtracted, minus the expected inflation rate. For a person facing a 30% tax rate, the after-tax interest rate earned on a bond yielding 10% is only 7% because
30% of the interest income must be paid to the Internal Revenue Service. Thus, the after-tax real interest rate on this bond when expected inflation is 20% equals -13% (= 7% - 20%). More generally, the
after-tax real interest rate can be expressed as
i(1 - τ) - πe
where τ = the income tax rate.
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With TIPS, Real Interest Rates Have Become
Observable in the United States
When the U.S. Treasury decided to issue TIPS
(Treasury Inflation Protection Securities), a version of
indexed coupon bonds, it was somewhat late in the
game. Other countries such as the United Kingdom,
Canada, Australia, and Sweden had beaten the United
States to the punch. (In September 1998, the U.S.
Treasury also began issuing the Series I savings bond,
which provides inflation protection for small investors.)
These indexed securities have successfully acquired
a niche in the bond market, enabling governments to
raise more funds. In addition, because their interest
and principal payments are adjusted for changes
in the price level, the interest rate on these bonds
provides a direct measure of a real interest rate. These
indexed bonds are very useful to policy makers, especially monetary policy makers, because by subtracting
their interest rate from a nominal interest rate, they
generate more insight into expected inflation, a valuable piece of information. For example, on May 13,
2016, the interest rate on the 10-year Treasury bond
was 1.71%, while that on the 10-year TIPS was
0.13%. Thus, the implied expected inflation rate for
the next 10 years, derived from the difference between
these two rates, was 1.58%. The private sector finds
the information provided by TIPS very useful: Many
commercial and investment banks routinely publish
the expected U.S. inflation rates derived from these
bonds.
Until recently, real interest rates in the United States were not observable
because only nominal rates were reported. This all changed in January 1997, when
the U.S. Treasury began to issue indexed bonds, bonds whose interest and principal
payments are adjusted for changes in the price level (see the Mini-Case box above).
The Distinction Between Interest Rates and Returns
Many people think that the interest rate on a bond tells them all they need to know
about how well off they are as a result of owning it. If Irving the investor thinks he
is better off when he owns a long-term bond yielding a 10% interest rate and the
interest rate rises to 20%, he will have a rude awakening: As we will shortly see,
Irving has lost his shirt! How well a person does by holding a bond or any other
security over a particular time period is accurately measured by the return, or, in
more precise terminology, the rate of return. The concept of return discussed
here is extremely important because it is used continually throughout the book.
This formula for the after-tax real interest rate also provides a better measure of the effective
cost of borrowing for many corporations and individuals in the United States because in calculating
income taxes, they can deduct interest payments on loans from their income. Thus, if you face a 30%
tax rate and take out a mortgage loan with a 10% interest rate, you are able to deduct the 10% interest
payment and thus lower your taxes by 30% of this amount. Your after-tax nominal cost of borrowing is
then 7% (10% minus 30% of the 10% interest payment), and when the expected inflation rate is 20%,
the effective cost of borrowing in real terms is again -13% (= 7% - 20%).
As the example (and the formula) indicates, after-tax real interest rates are always below the
real interest rate defined by the Fisher equation. For a further discussion of measures of after-tax real
interest rates, see Frederic S. Mishkin, “The Real Interest Rate: An Empirical Investigation,” CarnegieRochester Conference Series on Public Policy 15 (1981): 151–200.
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Make sure that you understand how a return is calculated and why it can differ from
the interest rate. This understanding will make the material presented later in the
book easier to follow.
For any security, the rate of return is defined as the payments to the owner plus
the change in its value, expressed as a fraction of its purchase price. To make this
definition clearer, let us see what the return would look like for a $1,000-face-value
coupon bond with a coupon rate of 10% that is bought for $1,000, held for one year,
and then sold for $1,200. The payments to the owner are the yearly coupon payments of $100, and the change in its value is $1,200 - $1,000 = $200. Adding these
together and expressing them as a fraction of the purchase price of $1,000 gives us
the one-year holding-period return for this bond:
$100 + $200
$300
=
= 0.30 = 30,
$1,000
$1,000
You may have noticed something quite surprising about the return that we have
just calculated: It equals 30%, yet as Table 3.1 indicates, initially the yield to maturity was only 10%. This discrepancy demonstrates that the return on a bond will
not necessarily equal the interest rate on that bond. We now see that the
distinction between interest rate and return can be important, although for many
securities the two may be closely related.
More generally, the return on a bond held from time t to time t + 1 can be written as
R =
where
C + Pt + 1 - Pt
Pt
(9)
R = return from holding the bond from time t to time t + 1
Pt = price of the bond at time t
Pt+1 = price of the bond at time t + 1
C = coupon payment
EXAMPLE 3.7
Rate of Return
What would the rate of return be on a bond bought for $1,000 and sold one year later
for $800? The bond has a face value of $1,000 and a coupon rate of 8%.
Solution
The rate of return on the bond for holding it one year is -12%.
R =
C + Pt + 1 - Pt
Pt
where
C
= coupon payment = $1,000 * 0.08 = $80
Pt+1 = price of the bond one year later
Pt
= price of the bond today
= $800
= $1,000
Thus,
R =
$80 + ($800 - $1,000)
-120
=
= -0.12 = -12,
$1,000
1,000
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A convenient way to rewrite the return formula in Equation 9 is to recognize
that it can be split into two terms:
R =
Pt + 1 - Pt
C
+
Pt
Pt
The first term is the current yield ic (the coupon payment over the purchase price):
C
= ic
Pt
The second term is the rate of capital gain, or the change in the bond’s price
relative to the initial purchase price:
Pt + 1 - Pt
= g
Pt
where g = rate of capital gain. Equation 9 can then be rewritten as
R = ic + g
(10)
which shows that the return on a bond is the current yield ic plus the rate of capital
gain g. This rewritten formula illustrates the point we just discovered. Even for a
bond for which the current yield ic is an accurate measure of the yield to maturity,
the return can differ substantially from the interest rate. Returns will differ from the
interest rate especially if the price of the bond experiences sizable fluctuations,
which then produce substantial capital gains or losses.
To explore this point even further, let’s look at what happens to the returns on
bonds of different maturities when interest rates rise. Using Equation 10 above,
Table 3.2 calculates the one-year return on several 10% coupon rate bonds all purchased at par when interest rates on all these bonds rise from 10% to 20%. Several
key findings in this table are generally true of all bonds:
• The only bond whose return equals the initial yield to maturity is one whose time
to maturity is the same as the holding period (see the last bond in Table 3.2).
• A rise in interest rates is associated with a fall in bond prices, resulting in
capital losses on bonds whose terms to maturity are longer than the holding
period.
• The more distant a bond’s maturity, the greater the size of the price change
associated with an interest-rate change.
• The more distant a bond’s maturity, the lower the rate of return that occurs
as a result of the increase in the interest rate.
• Even though a bond has a substantial initial interest rate, its return can turn
out to be negative if interest rates rise.
At first, it frequently puzzles students that a rise in interest rates can mean that
a bond has been a poor investment (as it puzzles poor Irving the investor). The trick
to understanding this is to recognize that a rise in the interest rate means that the
price of a bond has fallen. A rise in interest rates therefore means that a capital loss
has occurred, and if this loss is large enough, the bond can be a poor investment
indeed. For example, we see in Table 3.2 that the bond that has 30 years to maturity
when purchased has a capital loss of 49.7% when the interest rate rises from 10%
to 20%. This loss is so large that it exceeds the current yield of 10%, resulting in a
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TABLE 3.2 O
ne-Year Returns on Different-Maturity 10% Coupon Rate Bonds
When Interest Rates Rise from 10% to 20%
(1)
Years to
Maturity
When Bond
Is Purchased
(2)
(3)
(4)
(5)
(6)
Initial
Current
Yield (%)
Initial
Price ($)
Price Next
Year* ($)
Rate of
Capital
Gain (%)
Rate of
Return
(2 + 5) (%)
30
10
1,000
503
−49.7
−39.7
20
10
1,000
516
−48.4
−38.4
10
10
1,000
597
−40.3
−30.3
5
10
1,000
741
−25.9
−15.9
2
10
1,000
917
−8.3
+1.7
1
10
1,000
1,000
0.0
+10.0
*Calculated with a financial calculator using Equation 3.
negative return (loss) of –39.7%. If Irving does not sell the bond, the capital loss is
often referred to as a “paper loss.” This is a loss nonetheless because if he had not
bought this bond and had instead put his money in the bank, he would now be able
to buy more bonds at their lower price than he presently owns.
Maturity and the Volatility of Bond Returns:
Interest-Rate Risk
The finding that the prices of longer-maturity bonds respond more dramatically to
changes in interest rates helps explain an important fact about the behavior of bond
markets: Prices and returns for long-term bonds are more volatile than
those for shorter-term bonds. Price changes of +20% and -20% within a year,
with corresponding variations in returns, are common for bonds more than 20 years
away from maturity.
We now see that changes in interest rates make investments in long-term bonds
quite risky. Indeed, the riskiness of an asset’s return that results from interest-rate
changes is so important that it has been given a special name, interest-rate risk.
Dealing with interest-rate risk is a major concern of managers of financial institutions and investors, as we will see in later chapters (see also the Mini-Case box).
Although long-term debt instruments have substantial interest-rate risk, shortterm debt instruments do not. Indeed, bonds with a maturity that is as short as the
holding period have no interest-rate risk.6 We see this for the coupon bond at the
6
The statement that there is no interest-rate risk for any bond whose time to maturity matches the
holding period is literally true only for discount bonds and zero-coupon bonds that make no intermediate cash payments before the holding period is over. A coupon bond that makes an intermediate cash
payment before the holding period is over requires that this payment be reinvested at some future
date. Because the interest rate at which this payment can be reinvested is uncertain, there is some
uncertainty about the return on this coupon bond even when the time to maturity equals the holding
period. However, the riskiness of the return on a coupon bond from reinvesting the coupon payments
is typically quite small, and so the basic point that a coupon bond with a time to maturity equaling the
holding period has very little risk still holds true.
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Helping Investors Select Desired
Interest-Rate Risk
Because many investors want to know how much
interest-rate risk they are exposed to, some mutual
fund companies try to educate investors about the
perils of interest-rate risk, as well as to offer investment
alternatives that match their investors’ preferences.
Vanguard Group, for example, offers eight highgrade bond mutual funds. In its prospectus, Vanguard separates the funds by the average maturity
of the bonds they hold and demonstrates the effect
of interest-rate changes by computing the percentage change in bond value resulting from a 1%
increase and decrease in interest rates. Three of
the funds invest in bonds with average maturities of
one to three years, which Vanguard rates as having
the lowest interest-rate risk. Three other funds hold
bonds with average maturities of five to ten years,
which Vanguard rates as having medium interest-rate
risk. Two funds hold long-term bonds with maturities
of 15 to 30 years, which Vanguard rates as having
high interest-rate risk.
By providing this information, Vanguard hopes to
increase its market share in the sales of bond funds.
Not surprisingly, Vanguard is one of the most successful mutual fund companies in the business.
bottom of Table 3.2, which has no uncertainty about the rate of return because it
equals the yield to maturity, which is known at the time the bond is purchased. The
key to understanding why there is no interest-rate risk for any bond whose time to
maturity matches the holding period is to recognize that (in this case) the price at
the end of the holding period is already fixed at the face value. The change in interest rates can then have no effect on the price at the end of the holding period for
these bonds, and the return will therefore be equal to the yield to maturity known
at the time the bond is purchased.
Reinvestment Risk
Up to now, we have been assuming that all holding periods are short and equal to
the maturity on short-term bonds and are thus not subject to interest-rate risk.
However, if an investor’s holding period is longer than the term to maturity of the
bond, the investor is exposed to a type of interest-rate risk called reinvestment
risk. Reinvestment risk occurs because the proceeds from the short-term bond
need to be reinvested at a future interest rate that is uncertain.
To understand reinvestment risk, suppose that Irving the investor has a holding
period of two years and decides to purchase a $1,000 one-year, 10% coupon rate
bond at face value and then purchase another one at the end of the first year. If the
initial interest rate is 10%, Irving will have $1,100 at the end of the year. If the interest rate on one-year bonds rises to 20% at the end of the year, as in Table 3.2, Irving
will find that buying $1,100 worth of another one-year bond will leave him at the end
of the second year with $1,100 * 11 + 0.202 = $1,320. Thus, Irving’s two-year
return will be 1$1,320 - $1,0002>$1,000 = 0.32 = 32%, which equals 14.9% at an
annual rate. In this case, Irving has earned more by buying the one-year bonds than
if he had initially purchased the two-year bond with an interest rate of 10%. Thus,
when Irving has a holding period that is longer than the term to maturity of the
bonds he purchases, he benefits from a rise in interest rates. Conversely, if interest
rates on one-year bonds fall to 5% at the end of the year, Irving will have only $1,155
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at the end of two years: $1,100 * 11 + 0.052. Thus, his two-year return will be
1$1,155 - $1,0002/$1,000 = 0.155 = 15.5%, which is 7.2% at an annual rate. With
a holding period greater than the term to maturity of the bond, Irving now loses from
a fall in interest rates.
We have thus seen that when the holding period is longer than the term to
maturity of a bond, the return is uncertain because the future interest rate when
reinvestment occurs is also uncertain—in short, there is reinvestment risk. We
also see that if the holding period is longer than the term to maturity of the bond,
the investor benefits from a rise in interest rates and is hurt by a fall in interest
rates.
Summary
The return on a bond, which tells you how good an investment it has been over the
holding period, is equal to the yield to maturity in only one special case: when the
holding period and the maturity of the bond are identical. Bonds whose term to
maturity is longer than the holding period are subject to interest-rate risk: Changes
in interest rates lead to capital gains and losses that produce substantial differences
between the return and the yield to maturity known at the time the bond is purchased. Interest-rate risk is especially important for long-term bonds, where the
capital gains and losses can be substantial. This is why long-term bonds are not
considered to be safe assets with a sure return over short holding periods. Bonds
whose term to maturity is shorter than the holding period are also subject to reinvestment risk. Reinvestment risk occurs because the proceeds from the short-term
bond need to be reinvested at a future interest rate that is uncertain.
THE PRACTICING MANAGER
Calculating Duration to Measure Interest-Rate Risk
Earlier in our discussion of interest-rate risk, we saw that when interest rates
change, a bond with a longer term to maturity has a larger change in its price and
hence more interest-rate risk than a bond with a shorter term to maturity. Although
this is a useful general fact, in order to measure interest-rate risk, the manager of
a financial institution needs more precise information on the actual capital gain or
loss that occurs when the interest rate changes by a certain amount. To do this, the
manager needs to make use of the concept of duration, the average lifetime of a
debt security’s stream of payments.
The fact that two bonds have the same term to maturity does not mean that
they have the same interest-rate risk. A long-term discount bond with 10 years to
maturity, a so-called zero-coupon bond, makes all of its payments at the end of the
10 years, whereas a 10% coupon bond with 10 years to maturity makes substantial
cash payments before the maturity date. Since the coupon bond makes payments
earlier than the zero-coupon bond, we might intuitively guess that the coupon bond’s
effective maturity, the term to maturity that accurately measures interest-rate risk,
is shorter than it is for the zero-coupon discount bond.
Indeed, this is exactly what we find in Example 3.8.
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EXAMPLE 3.8
Rate of Capital
Gain
Calculate the rate of capital gain or loss on a 10-year zero-coupon bond for which the
interest rate has increased from 10% to 20%. The bond has a face value of $1,000.
Solution
The rate of capital gain or loss is -49.7%.
g =
Pt + 1 - Pt
Pt
where
Pt +1 = price of the bond one year from now =
Pt
= price of the bond today
=
$1,000
(1 + 0.20)9
$1,000
(1 + 0.10)10
= $193.81
= $385.54
Thus,
g =
$193.81 - $385.54
$385.54
g = -0.497 = -49.7%
But as we have already calculated in Table 3.2, the capital gain on the 10%
10-year coupon bond is –40.3%. We see that interest-rate risk for the 10-year coupon
bond is less than for the 10-year zero-coupon bond, so the effective maturity on the
coupon bond (which measures interest-rate risk) is, as expected, shorter than the
effective maturity on the zero-coupon bond.
Calculating Duration
To calculate the duration or effective maturity on any debt security, Frederick
Macaulay, a researcher at the National Bureau of Economic Research, invented the
concept of duration more than half a century ago. Because a zero-coupon bond
makes no cash payments before the bond matures, it makes sense to define its effective maturity as equal to its actual term to maturity. Macaulay then realized that he
could measure the effective maturity of a coupon bond by recognizing that a coupon
bond is equivalent to a set of zero-coupon discount bonds. A 10-year 10% coupon
bond with $1,000 face value has cash payments identical to the following set of zerocoupon bonds: a $100 one-year zero-coupon bond (which pays the equivalent of the
$100 coupon payment made by the $1,000 10-year 10% coupon bond at the end of
one year), a $100 two-year zero-coupon bond (which pays the equivalent of the
$100 coupon payment at the end of two years), . . . , a $100 10-year zero-coupon
bond (which pays the equivalent of the $100 coupon payment at the end of 10
years), and a $1,000 10-year zero-coupon bond (which pays back the equivalent of
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the coupon bond’s $1,000 face value). This set of coupon bonds is shown in the following timeline:
Year When Paid
0
1
Amount
$100
2
3
4
5
6
7
8
9
10
$100
$100
$100
$100
$100
$100
$100
$100
$100
$1,000
This same set of coupon bonds is listed in column (2) of Table 3.3, which calculates
the duration on the 10-year coupon bond when its interest rate is 10%.
To get the effective maturity of this set of zero-coupon bonds, we would want
to sum up the effective maturity of each zero-coupon bond, weighting it by the percentage of the total value of all the bonds that it represents. In other words, the
duration of this set of zero-coupon bonds is the weighted average of the effective
maturities of the individual zero-coupon bonds, with the weights equaling the proportion of the total value represented by each zero-coupon bond. We do this in
several steps in Table 3.3. First we calculate the present value of each of the zerocoupon bonds when the interest rate is 10% in column (3). Then in column (4) we
divide each of these present values by $1,000, the total present value of the set of
zero-coupon bonds, to get the percentage of the total value of all the bonds that
each bond represents. Note that the sum of the weights in column (4) must total
100%, as shown at the bottom of the column.
To get the effective maturity of the set of zero-coupon bonds, we add up the
weighted maturities in column (5) and obtain the figure of 6.76 years. This figure
TABLE 3.3 C
alculating Duration on a $1,000 Ten-Year 10% Coupon Bond When
Its Interest Rate Is 10%
(1)
(2)
Year
Cash Payments
(Zero-Coupon
Bonds) ($)
(3)
Present Value
(PV) of Cash
Payments
(i = 10%) ($)
(4)
Weights (%
of total PV =
PV/$1,000)
(%)
(5)
Weighted Maturity
(1 × 4)/100
(years)
1
100
90.91
9.091
0.09091
2
100
82.64
8.264
0.16528
3
100
75.13
7.513
0.22539
4
100
68.30
6.830
0.27320
5
100
62.09
6.209
0.31045
6
100
56.44
5.644
0.33864
7
100
51.32
5.132
0.35924
8
100
46.65
4.665
0.37320
9
100
42.41
4.241
0.38169
10
100
38.55
3.855
0.38550
10
1,000
Total
385.54
38.554
3.85500
1,000.00
100.000
6.75850
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for the effective maturity of the set of zero-coupon bonds is the duration of the 10%
10-year coupon bond because the bond is equivalent to this set of zero-coupon
bonds. In short, we see that duration is a weighted average of the maturities
of the cash payments.
The duration calculation done in Table 3.3 can be written as follows:
n
n
CPt
CPt
DUR = a t
tn a
(1
+
i)
(1
+ i)t
t=1
t=1
where
DUR
t
CPt
i
n
=
=
=
=
=
(11)
duration
years until cash payment is made
cash payment (interest plus principal) at time t
interest rate
years to maturity of the security
This formula is not as intuitive as the calculation done in Table 3.3, but it does have
the advantage that it can easily be programmed into a calculator or computer, making duration calculations very easy.
If we calculate the duration for an 11-year 10% coupon bond when the interest
rate is again 10%, we find that it equals 7.14 years, which is greater than the
6.76 years for the 10-year bond. Thus, we have reached the expected conclusion:
All else being equal, the longer the term to maturity of a bond, the longer
its duration.
You might think that knowing the maturity of a coupon bond is enough to tell
you what its duration is. However, that is not the case. To see this and to give you
more practice in calculating duration, in Table 3.4 we again calculate the duration
TABLE 3.4 C
alculating Duration on a $1,000 Ten-Year 10% Coupon Bond When
Its Interest Rate Is 20%
(1)
(2)
Year
Cash Payments
(Zero-Coupon
Bonds) ($)
(3)
Present Value
(PV) of Cash
Payments
(i = 20%) ($)
(5)
(4)
Weights (%
of total PV =
PV /$580.76)
(%)
Weighted
Maturity (1 ×
4)/100 (years)
1
100
83.33
14.348
0.14348
2
100
69.44
11.957
0.23914
3
100
57.87
9.965
0.29895
4
100
48.23
8.305
0.33220
5
100
40.19
6.920
0.34600
6
100
33.49
5.767
0.34602
7
100
27.91
4.806
0.33642
8
100
23.26
4.005
0.32040
9
100
19.38
3.337
0.30033
10
100
16.15
2.781
0.27810
10
1,000
161.51
27.808
2.78100
580.76
100.000
5.72204
Total
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for the 10-year 10% coupon bond, but when the current interest rate is 20% rather
than 10%, as in Table 3.3. The calculation in Table 3.4 reveals that the duration of
the coupon bond at this higher interest rate has fallen from 6.76 years to 5.72 years.
The explanation is fairly straightforward. When the interest rate is higher, the cash
payments in the future are discounted more heavily and become less important in
present-value terms relative to the total present value of all the payments. The relative weight for these cash payments drops as we see in Table 3.4, and so the effective maturity of the bond falls. We have come to an important conclusion: All else
being equal, when interest rates rise, the duration of a coupon bond falls.
The duration of a coupon bond is also affected by its coupon rate. For example,
consider a 10-year 20% coupon bond when the interest rate is 10%. Using the same
procedure, we find that its duration at the higher 20% coupon rate is 5.98 years
versus 6.76 years when the coupon rate is 10%. The explanation is that a higher
coupon rate means that a relatively greater amount of the cash payments is made
earlier in the life of the bond, and so the effective maturity of the bond must fall. We
have thus established a third fact about duration: All else being equal, the higher
the coupon rate on the bond, the shorter the bond’s duration.
One additional fact about duration makes this concept useful when applied to a
portfolio of securities. Our examples have shown that duration is equal to the
weighted average of the durations of the cash payments (the effective maturities of
the corresponding zero-coupon bonds). So if we calculate the duration for two different securities, it should be easy to see that the duration of a portfolio of the two
securities is just the weighted average of the durations of the two securities, with
the weights reflecting the proportion of the portfolio invested in each.
EXAMPLE 3.9
Duration of a
Portfolio
A manager of a financial institution is holding 25% of a portfolio in a bond with a fiveyear duration and 75% in a bond with a 10-year duration. What is the duration of the
portfolio?
Solution
The duration of the portfolio is 8.75 years.
(0.25 * 5) + (0.75 * 10) = 1.25 + 7.5 = 8.75 years
We now see that the duration of a portfolio of securities is the weighted
average of the durations of the individual securities, with the weights
reflecting the proportion of the portfolio invested in each. This fact about
duration is often referred to as the additive property of duration, and it is
extremely useful because it means that the duration of a portfolio of securities is
easy to calculate from the durations of the individual securities.
To summarize, our calculations of duration for coupon bonds have revealed four
facts:
1. The longer the term to maturity of a bond, everything else being equal, the
greater its duration.
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101
2. When interest rates rise, everything else being equal, the duration of a coupon
bond falls.
3. The higher the coupon rate on the bond, everything else being equal, the
shorter the bond’s duration.
4. Duration is additive: The duration of a portfolio of securities is the weighted
average of the durations of the individual securities, with the weights reflecting the proportion of the portfolio invested in each.
Duration and Interest-Rate Risk
Now that we understand how duration is calculated, we want to see how it can be
used by the practicing financial institution manager to measure interest-rate risk.
Duration is a particularly useful concept because it provides a good approximation, particularly when interest-rate changes are small, for how much the security
price changes for a given change in interest rates, as the following formula
indicates:
,∆ P ≈ -DUR *
∆i
1 + i
(12)
%ΔP = (Pt + 1 - Pt )>Pt = percentage change in the price of the
security from t to t + 1 = rate of capital gain
DUR = duration
i = interest rate
where
EXAMPLE 3.10
Duration and
Interest-Rate
Risk
A pension fund manager is holding a 10-year 10% coupon bond in the fund’s portfolio,
and the interest rate is currently 10%. What loss would the fund be exposed to if the
interest rate rises to 11% tomorrow?
Solution
The approximate percentage change in the price of the bond is –6.15%.
As the calculation in Table 3.3 shows, the duration of a 10-year 10% coupon bond
is 6.76 years.
,∆P ≈ -DUR *
∆i
1 + i
where
DUR = duration
= 6.76
Δi
= change in interest rate = 0.11 - 0.10 = 0.01
i
= current interest rate
= 0.10
Thus,
,∆P ≈ -6.76 *
0.01
1 + 0.10
,∆P ≈ -0.0615 = -6.15,
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EXAMPLE 3.11
Duration and
Interest-Rate
Risk
Now the pension manager has the option to hold a 10-year coupon bond with a coupon
rate of 20% instead of 10%. As mentioned earlier, the duration for this 20% coupon
bond is 5.98 years when the interest rate is 10%. Find the approximate change in the
bond price when the interest rate increases from 10% to 11%.
Solution
This time the approximate change in bond price is –5.4%. This change in bond price is
much smaller than for the higher-duration coupon bond.
%∆ P ≈ -DUR *
∆i
1 + i
where
DUR = duration
= 5.98
Δi
= change in interest rate = 0.11 - 0.10 = 0.01
i
= current interest rate
= 0.10
Thus,
0.01
1 + 0.10
%∆P ≈ -0.054 = -5.4%
%∆P ≈ -5.98 *
The pension fund manager realizes that the interest-rate risk on the 20% coupon bond
is less than on the 10% coupon bond, so he switches the fund out of the 10% coupon
bond and into the 20% coupon bond.
Examples 3.10 and 3.11 have led the pension fund manager to an important
conclusion about the relationship of duration and interest-rate risk: The greater
the duration of a security, the greater the percentage change in the market value of the security for a given change in interest rates. Therefore,
the greater the duration of a security, the greater its interest-rate risk.
This reasoning applies equally to a portfolio of securities. So by calculating the
duration of the fund’s portfolio of securities using the methods outlined here, a pension fund manager can easily ascertain the amount of interest-rate risk the entire
fund is exposed to. As we will see in Chapter 23, duration is a highly useful concept
for the management of interest-rate risk that is widely used by managers of banks
and other financial institutions.
SUMMARY
1. The yield to maturity, which is the measure most
accurately reflecting the interest rate, is the interest rate that equates the present value of future
cash flows of a debt instrument with its value today.
Application of this principle reveals that bond prices
and interest rates are negatively related: When the
interest rate rises, the price of the bond must fall,
and vice versa.
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2. The real interest rate is defined as the nominal interest rate minus the expected rate of inflation. It is
both a better measure of the incentives to borrow
and lend and a more accurate indicator of the tightness of credit market conditions than the nominal
interest rate.
3. The return on a security, which tells you how well
you have done by holding this security over a stated
period of time, can differ substantially from the
interest rate as measured by the yield to maturity.
Long-term bond prices have substantial fluctuations
when interest rates change and thus bear interestrate risk. The resulting capital gains and losses can
be large, which is why long-term bonds are not considered to be safe assets with a sure return. Bonds
whose maturity is shorter than the holding period
are also subject to reinvestment risk, which occurs
because the proceeds from the short-term bond
103
need to be reinvested at a future interest rate that
is uncertain.
4. Duration, the average lifetime of a debt security’s
stream of payments, is a measure of effective maturity, the term to maturity that accurately measures
interest-rate risk. Everything else being equal, the
duration of a bond is greater the longer the maturity of a bond, when interest rates fall, or when the
coupon rate of a coupon bond falls. Duration is additive: The duration of a portfolio of securities is the
weighted average of the durations of the individual
securities, with the weights reflecting the proportion of the portfolio invested in each. The greater
the duration of a security, the greater the percentage change in the market value of the security for
a given change in interest rates. Therefore, the
greater the duration of a security, the greater its
interest-rate risk.
KEY TERMS
cash flows, p. 78
coupon bond, p. 80
coupon rate, p. 80
current yield, p. 86
discount bond (zero-coupon bond),
p. 80
duration, p. 96
face value (par value), p. 80
fixed-payment loan (fully amortized
loan), p. 80
indexed bonds, p. 91
interest-rate risk, p. 94
nominal interest rate, p. 88
perpetuity (consol), p. 85
present value (present discounted
value), p. 78
rate of capital gain, p. 93
real interest rate, p. 88
real terms, p. 89
reinvestment risk, p. 95
return (rate of return), p. 91
simple loan, p. 78
yield to maturity, p. 81
QUESTIONS
1. What is the concept of present value? What is
discounting?
2. Analyze the risk profiles of short-term bonds and
long-term bonds during economic instability and
fluctuating interest rates.
4. Property investment constitutes a large and longterm commitment to an individual. Describe the
outcome of taking a property loan during fluctuating
interest rates.
3. What is the yield to maturity? Why it is considered as
a good measure of interest rates?
Q U A N T I TAT I V E P R O B L E M S
1. Calculate the present value of a $1,000 zero-coupon
bond with six years to maturity if the yield to maturity is 7%.
2. A lottery claims its grand prize is $20 million, payable
over 40 years at $500,000 per year. If the first payment is made immediately, what is the grand prize
worth? Use an interest rate of 12%.
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3. Consider a bond with an 8% annual coupon and a face
value of $1,000. Complete the following table:
Years to
Maturity
Yield to
Maturity
4
6
5
8
7
9
10
11
11
12
Current
Price
rate falls to 6%? What conclusion can you draw
from these cases?
11. Calculate the duration of a five-year bond with a face
value of $1,000 and a coupon rate of 8%. Assume that
the current interest rates are 10%. What will your
answer be if the current interest rates fall to 7%?
Show all your calculations.
12. Using the data provided in the previous problem,
calculate the price difference using the duration
formula
13. Financial institutions hold a portfolio comprising the
following securities:
4. Consider a coupon bond which has a $1,000 par value
and a coupon rate of 20%. The bond is currently selling for $2,300 and has 16 years to maturity. Calculate
the bond’s yield to maturity.
5. You are willing to pay $31,250 now to purchase a
perpetuity that will pay you and your heirs $2,500
each year, forever, starting at the end of this year.
If your required rate of return does not change,
how much would you be willing to pay if this were a
40-year, annual payment, ordinary annuity instead
of perpetuity?
6. Calculate the yield to maturity on the bond that has
a price of $1,000 and pays $50 dividend for the life
of the bond. What will happen if the dividend is $25
instead of $50?
7. Suppose you bought a land that costs $500,000 today.
You will need to continue to pay tax on the land, and
the rate is 3% of your purchase. Calculate the PV of
your payment, using a 10% discount rate. Assume
that there are no changes in the land’s price and tax
rate.
8. Suppose that you want to take out a loan at a bank
that wants to charge you an annual real interest rate
equal to 5%. Assuming that the expected rate of inflation during the life of the loan is 2%, what will be the
nominal interest rate that the bank will charge you? If
the real inflation was 3% instead of the expected 2%,
what was the actual real interest rate on the loan?
9. Anna bought a bond with a par value of $10,000 and a
coupon rate of 8% at par. After a year, she was able to
sell her bond for $11,000. Calculate the rate of return
on Anna’s investment. What is the current yield and
capital gain on her investment?
10. Suppose that you have a bond with a face value
of $1,000 and a coupon rate of 8% for one year
and that you buy another one after one year. What
will be your gain if the interest rate increases up to
10%? How will your answer change if the interest
10 million bond with duration 4 years
20 million securities with duration 6 years
40 million bonds with duration 5 years
What is the duration of the total portfolio?
14. A bank has two 3-year commercial loans with a present value of $70 million. The first is a $30 million
loan that requires a single payment of $37.8 million
in three years, with no other payments till then. The
second loan is for $40 million. It requires an annual
interest payment of $3.6 million. The principal of
$40 million is due in three years.
a. What is the duration of the bank’s commercial loan
portfolio?
b. What will happen to the value of its portfolio if
the general level of interest rates increases from
8% to 8.5%?
15. Consider a bond that promises the following cash
flows. The yield to maturity is 12%.
Year
Promised
Payments
0
1
2
3
4
160
160
170
180
230
You plan to buy this bond, hold it for 2.5 years, and
then sell the bond.
a. What total cash will you receive from the bond
after the 2.5 years? Assume that periodic cash
flows are reinvested at 12%.
b. If immediately after you buy this bond all market
interest rates drop to 11% (including your reinvestment rate), what will be the impact on your
total cash flow after 2.5 years? How does this compare to part (a)?
c. Assuming all market interest rates are 12%, what
is the duration of this bond?
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