Financial Markets & Institutions Textbook, 10th Edition

HIGHLIGHTS • New: Mini-Case boxes on relevant topics like Twitter’s use of a shareholder rights plan to drive a hard bargain with Elon Musk, money market fund withdrawals due to Covid, and differences between real and nominal interest rates; Case boxes on subjects like Brexit’s effect on the British pound and the effects of Trump tax cuts on bond interest rates bolster students’ understanding of financial events. • Updated: The section on nonconventional monetary policy tools and quantitative easing has been updated to discuss their utilization during the Covid crisis. • International focus: Global boxes, which discuss diverse issues like the European sovereign debt crisis, international financial regulation, and Argentina’s currency board, ensure the text has ample focus on pertinent financial topics from around the world. CVR_MISH9547_10_GE_CVR_CPI.indd All Pages TENTH EDITION Frederic S. Mishkin • Stanley G. Eakins Mishkin Eakins • Structured chapters: Each chapter begins with a chapter Preview that sets the tone for what follows and ends with a Summary that highlights the key takeaways. End-of-chapter Questions and Quantitative Problems put acquired knowledge to the test. Financial Markets and Institutions TENTH EDITION • Hallmarks:The Practicing Manager sections expose students to nearly 20 hands-on applications that highlight a financial practitioner’s approach. E-Finance boxes broaden the ambit of study by exploring the effects of technology on financial markets and institutions. Following the Financial News boxes help students stay on top of crucial news and data reported. Financial Markets and Institutions A bestseller over the past nine editions, Financial Markets and Institutions is a powerful classroom resource that serves as a comprehensive yet lucid introduction to the intricate mechanisms of today’s financial entities. Packed with case studies, numerical examples, graphs, and thorough discussions, the text encourages students to delve deep into theoretical concepts and their real-world applications. The tenth edition has incorporated compelling new material on the Covid pandemic and its wide-ranging impact on the financial world. This edition retains the previous editions’ characteristic technique of step-by-step development of concepts with dissection of the fundamentals, which equips students with a solid foundation for successful careers in finance. GLOBAL EDITION GLOB AL EDITION GLOBAL EDITION This is a special edition of an established title widely used by colleges and universities throughout the world. Pearson published this exclusive edition for the benefit of students outside the United States and Canada. If you purchased this book within the United States or Canada, you should be aware that it has been imported without the approval of the Publisher or Author. 24/05/23 10:46 AM FINANCIAL MARKETS AND INSTITUTIONS Tenth Edition Global Edition A01_MISH9547_10_GE_FM.indd 1 06/07/23 11:01 AM This page is intentionally left blank A01_MISH9547_10_GE_FM.indd 2 06/07/23 11:01 AM FINANCIAL MARKETS AND INSTITUTIONS Tenth Edition Global Edition Frederic S. Mishkin Graduate School of Business, Columbia University Stanley G. Eakins East Carolina University ˜ A01_MISH9547_10_GE_FM.indd 3 06/07/23 11:01 AM Product Management: Yajnaseni Das, Paromita Banerjee, Ishita Sinha, and Sohini Dasgupta Content Production: Nitin Shankar Product Marketing: Joanne Dieguez Rights and Permissions: Anjali Singh and Ashish Vyas Cover image: Niphon Subsri/Shutterstock Please contact https://support.pearson.com/getsupport/s/contactsupport with any queries on this content. Pearson Education Limited KAO Two KAO Park Hockham Way Harlow, Essex CM17 9SR United Kingdom and Associated Companies throughout the world Visit us on the World Wide Web at: www.pearsonglobaleditions.com © Pearson Education Limited 2024 The rights of Frederic S. Mishkin and Stanley G. Eakins to be identified as the authors of this work have been asserted by them in accordance with the Copyright, Designs and Patents Act 1988. Authorized adaptation from the United States edition, entitled Financial Markets and Institutions, 10th Edition, ISBN 978-0-13-804347-6, by Frederic S. Mishkin and Stanley G. Eakins, published by Pearson Education © 2024. Acknowledgments of third-party content appear on the appropriate page within the text. All rights reserved. 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ISBN 10 (Print): 1-292-45954-9 ISBN 13 (Print): 978-1-292-45954-7 ISBN 13 (uPDF eBook): 978-1-292-45953-0 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library eBook formatted by B2R Technologies Pvt. Ltd. To My Dad —F. S. M. To My Wife, Laurie —S. G. E. A01_MISH9547_10_GE_FM.indd 5 06/07/23 11:01 AM Pearson’s Commitment to Diversity, Equity, and Inclusion Pearson is dedicated to creating bias-free content that reflects the diversity, depth, and breadth of all learners’ lived experiences. We embrace the many dimensions of diversity, including but not limited to race, ethnicity, gender, sex, sexual orientation, socioeconomic status, ability, age, and religious or political beliefs. Education is a powerful force for equity and change in our world. It has the potential to deliver opportunities that improve lives and enable economic mobility. 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Accessibility Contact Us We are also committed to providing products that are fully accessible to all learners. As per Pearson’s guidelines for accessible educational Web media, we test and retest the capabilities of our products against the highest standards for every release, following the WCAG guidelines in developing new products for copyright year 2022 and beyond. While we work hard to present unbiased, fully accessible content, we want to hear from you about any concerns or needs with this Pearson product so that we can investigate and address them. You can learn more about Pearson’s commitment to accessibility at https://www.pearson.com/uk/accessibility.html A01_MISH9547_10_GE_FM.indd 6 Please contact us with concerns about any potential bias at https://www.pearson.com/report-bias.html For accessibility-related issues, such as using assistive technology with Pearson products, alternative text requests, or accessibility documentation, email the Pearson Disability Support team at disability.support@pearson.com 06/07/23 11:01 AM Contents in Brief PART ONE 1 2 PART TWO 3 4 5 6 PART THREE 7 8 PART FOUR 9 10 PART FIVE 11 12 13 14 15 16 PART SIX 17 18 19 20 Contents in Detail Contents on the Web Preface About the Authors 9 27 31 39 INTRODUCTION 41 Why Study Financial Markets and Institutions? Overview of the Financial System 41 55 FUNDAMENTALS OF FINANCIAL MARKETS 77 What Do Interest Rates Mean, and What Is Their Role in Valuation? Why Do Interest Rates Change? How Do Risk and Term Structure Affect Interest Rates? Are Financial Markets Efficient? 77 105 128 155 FUNDAMENTALS OF FINANCIAL INSTITUTIONS 173 Why Do Financial Institutions Exist? Why Do Financial Crises Occur, and Why Are They So Damaging to the Economy? 173 CENTRAL BANKING AND THE CONDUCT OF MONETARY POLICY 224 Central Banks Conduct of Monetary Policy 224 242 FINANCIAL MARKETS 284 The Money Markets The Bond Market The Stock Market The Mortgage Markets The Foreign Exchange Market The International Financial System 284 307 332 353 374 399 THE FINANCIAL INSTITUTIONS INDUSTRY 420 Banking and the Management of Financial Institutions Financial Regulation Banking Industry: Structure and Competition The Mutual Fund Industry 420 446 472 507 204 7 A01_MISH9547_10_GE_FM.indd 7 06/07/23 11:01 AM 8 Contents in Brief 21 22 PART SEVEN 23 24 Insurance Companies and Pension Funds Investment Banks, Security Brokers and Dealers, and Venture Capital Firms 531 THE MANAGEMENT OF FINANCIAL INSTITUTIONS 584 Risk Management in Financial Institutions Hedging with Financial Derivatives 584 605 Glossary Index Guide to Commonly Used Symbols G-1 I-1 S-1 561 ADDITIONAL CHAPTERS 25 26 27 A01_MISH9547_10_GE_FM.indd 8 Financial Crises in Emerging Market Economies Savings Associations and Credit Unions Finance Companies W-1 W-22 W-47 06/07/23 11:01 AM Contents in Detail Contents on the Web Preface About the Authors 27 31 39 PART ONE INTRODUCTION Chapter 1 Why Study Financial Markets and Institutions? 41 PREVIEW Why Study Financial Markets? Debt Markets and Interest Rates The Stock Market The Foreign Exchange Market Why Study Financial Institutions? Structure of the Financial System Financial Crises Central Banks and the Conduct of Monetary Policy MINI-CASE Are Bitcoin or Other Cryptocurrencies Money? The International Financial System Banks and Other Financial Institutions Financial Innovation Managing Risk in Financial Institutions Applied Managerial Perspective How We Will Study Financial Markets and Institutions Exploring the Web Collecting and Graphing Data Web Exercise Concluding Remarks SUMMARY KEY TERMS QUESTIONS QUANTITATIVE PROBLEM WEB EXERCISES 41 42 42 43 44 46 46 46 47 47 48 48 48 49 49 49 50 50 51 52 53 53 53 54 54 Overview of the Financial System 55 PREVIEW Function of Financial Markets Structure of Financial Markets Debt and Equity Markets Primary and Secondary Markets Exchanges and Over-the-Counter Markets Money and Capital Markets 55 56 58 58 58 59 60 Chapter 2 9 A01_MISH9547_10_GE_FM.indd 9 06/07/23 11:01 AM 10 Contents in Detail Internationalization of Financial Markets International Bond Market, Eurobonds, and Eurocurrencies GLOBAL Are U.S. Capital Markets Losing Their Edge? World Stock Markets Function of Financial Intermediaries: Indirect Finance FOLLOWING THE FINANCIAL NEWS Foreign Stock Market Indexes GLOBAL The Importance of Financial Intermediaries Relative to Securities Markets: An International Comparison Transaction Costs Risk Sharing Asymmetric Information: Adverse Selection and Moral Hazard Economies of Scope and Conflicts of Interest Types of Financial Intermediaries Depository Institutions Contractual Savings Institutions Investment Intermediaries Regulation of the Financial System Increasing Information Available to Investors Ensuring the Soundness of Financial Intermediaries Financial Regulation Abroad SUMMARY KEY TERMS QUESTIONS WEB EXERCISES PART TWO 63 63 64 65 66 67 67 68 70 71 72 72 73 74 75 75 76 FUNDAMENTALS OF FINANCIAL MARKETS Chapter 3What Do Interest Rates Mean, and What Is Their Role in Valuation? PREVIEW Measuring Interest Rates Present Value Four Types of Credit Market Instruments Yield to Maturity GLOBAL Negative Interest Rates? Japan First, Then the United States, Then Europe The Distinction Between Real and Nominal Interest Rates MINI-CASE Seeing the Difference Between Real and Nominal in Practice: Australian eTIBs The Distinction Between Interest Rates and Returns Maturity and the Volatility of Bond Returns: Interest-Rate Risk Reinvestment Risk Summary THE PRACTICING MANAGER Calculating Duration to Measure Interest-Rate Risk Calculating Duration Duration and Interest-Rate Risk SUMMARY KEY TERMS QUESTIONS A01_MISH9547_10_GE_FM.indd 10 60 60 61 62 62 63 77 77 78 78 80 81 87 88 90 91 94 95 95 96 97 100 102 102 103 06/07/23 11:01 AM Contents in Detail Chapter 4 Chapter 5 A01_MISH9547_10_GE_FM.indd 11 11 QUANTITATIVE PROBLEMS WEB EXERCISE 103 104 Why Do Interest Rates Change? 105 PREVIEW Determinants of Asset Demand Wealth Expected Returns Risk Liquidity Theory of Portfolio Choice Supply and Demand in the Bond Market Demand Curve Supply Curve Market Equilibrium Supply-and-Demand Analysis Changes in Equilibrium Interest Rates Shifts in the Demand for Bonds Shifts in the Supply of Bonds CASE Changes in the Interest Rate Due to Expected Inflation: The Fisher Effect CASE Changes in the Interest Rate Due to a Business Cycle Expansion CASE Explaining the Low Interest Rates in Europe, Japan, and the United States Before 2022 THE PRACTICING MANAGER Profiting from Interest-Rate Forecasts FOLLOWING THE FINANCIAL NEWS Forecasting Interest Rates SUMMARY KEY TERMS QUESTIONS QUANTITATIVE PROBLEMS WEB EXERCISES WEB APPENDICES 105 106 106 106 107 109 109 109 110 111 112 113 113 114 117 119 121 122 123 125 125 125 125 126 127 127 How Do Risk and Term Structure Affect Interest Rates? 128 PREVIEW Risk Structure of Interest Rates Default Risk Liquidity CASE The Coronavirus Pandemic and the Baa–Treasury Spread Income Tax Considerations Summary CASE Effects of the Trump Tax Cuts on Bond Interest Rates Term Structure of Interest Rates FOLLOWING THE FINANCIAL NEWS Yield Curves Expectations Theory Market Segmentation Theory Liquidity Premium Theory Evidence on the Term Structure 128 129 129 132 132 133 134 135 136 137 137 141 142 145 06/07/23 11:01 AM 12 Contents in Detail Chapter 6 MINI-CASE The Yield Curve as a Forecasting Tool for Inflation and the Business Cycle Summary CASE Interpreting Yield Curves, 1980–2022 THE PRACTICING MANAGER Using the Term Structure to Forecast Interest Rates SUMMARY KEY TERMS QUESTIONS QUANTITATIVE PROBLEMS WEB EXERCISES 147 147 148 149 152 152 152 153 154 Are Financial Markets Efficient? 155 PREVIEW The Efficient Market Hypothesis Rationale Behind the Hypothesis Evidence on the Efficient Market Hypothesis Evidence in Favor of Market Efficiency MINI-CASE An Exception That Proves the Rule: Raj Rajaratnam and Galleon CASE Should Foreign Exchange Rates Follow a Random Walk? Evidence Against Market Efficiency Overview of the Evidence on the Efficient Market Hypothesis THE PRACTICING MANAGER Practical Guide to Investing in the Stock Market How Valuable Are Published Reports by Investment Advisers? MINI-CASE Should You Hire an Ape as Your Investment Adviser? Should You Be Skeptical of Hot Tips? Do Stock Prices Always Rise When There Is Good News? Efficient Markets Prescription for the Investor Why the Efficient Market Hypothesis Does Not Imply That Financial Markets Are Efficient CASE What Do Stock Market Crashes Tell Us About the Efficient Market Hypothesis? Behavioral Finance SUMMARY KEY TERMS QUESTIONS QUANTITATIVE PROBLEMS WEB EXERCISE 155 156 158 159 159 160 162 163 165 165 165 166 166 167 167 168 169 169 170 171 171 172 172 PART THREE FUNDAMENTALS OF FINANCIAL INSTITUTIONS Chapter 7 Why Do Financial Institutions Exist? 173 P REVIEW Basic Facts About Financial Structure Throughout the World Transaction Costs How Transaction Costs Influence Financial Structure How Financial Intermediaries Reduce Transaction Costs 173 174 177 177 177 A01_MISH9547_10_GE_FM.indd 12 06/07/23 11:01 AM Contents in Detail Asymmetric Information: Adverse Selection and Moral Hazard The Lemons Problem: How Adverse Selection Influences Financial Structure Lemons in the Stock and Bond Markets Tools to Help Solve Adverse Selection Problems MINI-CASE The Enron Implosion How Moral Hazard Affects the Choice Between Debt and Equity Contracts Moral Hazard in Equity Contracts: The Principal–Agent Problem Tools to Help Solve the Principal–Agent Problem How Moral Hazard Influences Financial Structure in Debt Markets Tools to Help Solve Moral Hazard in Debt Contracts Summary CASE Financial Development and Economic Growth MINI-CASE The Tyranny of Collateral CASE Is China a Counter-Example to the Importance of Financial Development? Conflicts of Interest What Are Conflicts of Interest, and Why Do We Care? Why Do Conflicts of Interest Arise? CONFLICTS OF INTEREST The Demise of Arthur Andersen CONFLICTS OF INTEREST Credit-Rating Agencies and the 2007–2009 Financial Crisis What Has Been Done to Remedy Conflicts of Interest? MINI-CASE Has Sarbanes-Oxley Led to a Decline in U.S. Capital Markets? SUMMARY KEY TERMS QUESTIONS QUANTITATIVE PROBLEMS WEB EXERCISES 13 178 179 180 180 182 185 185 186 188 188 190 192 193 194 195 195 195 197 198 198 200 200 201 201 202 203 Chapter 8Why Do Financial Crises Occur, and Why Are They So Damaging to the Economy? 204 PREVIEW What Is a Financial Crisis? Agency Theory and the Definition of a Financial Crisis Dynamics of Financial Crises Stage One: Initial Phase Stage Two: Banking Crisis Stage Three: Debt Deflation CASE The Mother of All Financial Crises: The Great Depression Stock Market Crash Bank Panics Continuing Decline in Stock Prices Debt Deflation International Dimensions CASE The Global Financial Crisis of 2007–2009 Causes of the 2007–2009 Financial Crisis 204 205 205 205 205 208 209 209 209 209 210 211 211 212 212 A01_MISH9547_10_GE_FM.indd 13 06/07/23 11:01 AM 14 Contents in Detail MINI-CASE Collateralized Debt Obligations (CDOs) Effects of the 2007–2009 Financial Crisis INSIDE THE FED Was the Fed to Blame for the Housing Price Bubble? GLOBAL The European Sovereign Debt Crisis Height of the 2007–2009 Financial Crisis CASE Could Covid Have Led to a Financial Crisis? SUMMARY KEY TERMS QUESTIONS WEB EXERCISE WEB REFERENCES 213 214 215 218 219 220 221 222 222 223 223 PART FOUR CENTRAL BANKING AND THE CONDUCT OF MONETARY POLICY Chapter 9 A01_MISH9547_10_GE_FM.indd 14 Central Banks 224 PREVIEW Origins of the Central Banking System Variations in the Functions and Structures of Central Banks GLOBAL Who Should Own Central Banks? The European Central Bank, the Euro System, and the European System of Central Banks Decision-Making Bodies of the ECB GLOBAL The Importance of the Bundesbank Within the ECB How Monetary Policy Is Conducted Within the ECB GLOBAL Are Non-Euro Central Banks Constrained by Membership of the EU? The Federal Reserve System Difference Between the ECB and the Fed The Bank of England GLOBAL Brexit and the BoE Structure of Central Banks of Larger Economies The Bank of Canada The Bank of Japan The People’s Bank of China Structure and Independence of Central Banks of Emerging Market Economies Central Banks Independence The Case for Independence The Case Against Independence The Trend Toward Greater Independence SUMMARY KEY TERMS QUESTIONS AND PROBLEMS WEB EXERCISES 224 225 225 226 226 227 230 231 232 232 233 234 235 235 235 236 237 238 238 239 239 239 240 241 241 241 06/07/23 11:01 AM Contents in Detail Chapter 10 A01_MISH9547_10_GE_FM.indd 15 15 Conduct of Monetary Policy 242 PREVIEW How Fed Actions Affect Reserves in the Banking System Open Market Operations Discount Lending The Market for Reserves and the Federal Funds Rate Demand and Supply in the Market for Reserves How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate CASE How the Federal Reserve’s Operating Procedures Limit Fluctuations in the Federal Funds Rate Conventional Monetary Policy Tools Open Market Operations INSIDE THE FED A Day at the Trading Desk Discount Policy and the Lender of Last Resort Reserve Requirements Interest on Excess Reserves Nonconventional Monetary Policy Tools and Quantitative Easing Liquidity Provision INSIDE THE FED Fed Lending Facilities During the Global Financial and Covid Crises Large-Scale Asset Purchases Quantitative Easing Versus Credit Easing Forward Guidance Negative Interest Rates on Banks’ Deposits Monetary Policy Tools of the European Central Bank Open Market Operations Lending to Banks Interest on Excess Reserves Reserve Requirements The Price Stability Goal and the Nominal Anchor The Role of a Nominal Anchor The Time-Inconsistency Problem Other Goals of Monetary Policy High Employment and Output Stability Economic Growth Stability of Financial Markets Interest-Rate Stability Stability in Foreign Exchange Markets Should Price Stability Be the Primary Goal of Monetary Policy? Hierarchical Versus Dual Mandates Price Stability as the Primary, Long-Run Goal of Monetary Policy Inflation Targeting Advantages of Inflation Targeting INSIDE THE FED Ben Bernanke and the Federal Reserve’s Adoption of Inflation Targeting INSIDE THE FED The Fed’s New Monetary Policy Strategy: Average Inflation Targeting Disadvantages of Inflation Targeting 242 243 243 244 245 245 247 251 252 252 253 253 256 256 256 257 258 259 260 261 263 264 264 264 265 265 265 266 266 267 267 268 268 268 269 269 269 270 271 271 272 273 273 06/07/23 11:01 AM 16 Contents in Detail Should Central Banks Respond to Asset-Price Bubbles? Lessons from the Global Financial Crisis Two Types of Asset-Price Bubbles The Debate over Whether Central Banks Should Try to Pop Bubbles THE PRACTICING MANAGER Using a Fed Watcher SUMMARY KEY TERMS QUESTIONS QUANTITATIVE PROBLEMS WEB EXERCISES 274 275 276 279 280 281 281 282 283 PART FIVE FINANCIAL MARKETS Chapter 11 The Money Markets 284 PREVIEW The Money Markets Defined Why Do We Need the Money Markets? Money Market Cost Advantages The Purpose of the Money Markets MINI-CASE Covid and Prime Money Market Fund Withdrawals Who Participates in the Money Markets? U.S. Treasury Department Federal Reserve System Commercial Banks Businesses Investment and Securities Firms Individuals Money Market Instruments Treasury Bills CASE Discounting the Price of Treasury Securities to Pay the Interest MINI-CASE Treasury Bill Auctions Go Haywire Federal Funds Repurchase Agreements Negotiable Certificates of Deposit Commercial Paper Banker’s Acceptances Eurodollars GLOBAL Ironic Birth of the Eurodollar Market Comparing Money Market Securities Interest Rates Liquidity How Money Market Securities Are Valued SUMMARY KEY TERMS QUESTIONS QUANTITATIVE PROBLEMS WEB EXERCISES 284 285 285 286 287 288 288 288 289 289 290 290 290 291 291 291 294 295 296 297 298 300 301 301 302 302 303 304 305 305 305 306 306 A01_MISH9547_10_GE_FM.indd 16 06/07/23 11:01 AM Contents in Detail Chapter 12 Chapter 13 A01_MISH9547_10_GE_FM.indd 17 17 The Bond Market 307 PREVIEW Purpose of the Capital Market Capital Market Participants Capital Market Trading Types of Bonds Treasury Notes and Bonds Treasury Bond Interest Rates Treasury Inflation-Protected Securities (TIPS) Treasury STRIPS Agency Bonds CASE The 2007–2009 Financial Crisis and the Bailout of Fannie Mae and Freddie Mac Municipal Bonds Risk in the Municipal Bond Market Corporate Bonds Characteristics of Corporate Bonds Types of Corporate Bonds Financial Guarantees for Bonds Oversight of the Bond Markets Current Yield Calculation Current Yield Finding the Value of Coupon Bonds Finding the Price of Semiannual Bonds Investing in Bonds SUMMARY KEY TERMS QUESTIONS QUANTITATIVE PROBLEMS 307 308 308 309 309 309 310 312 312 312 313 314 316 316 317 319 322 323 323 324 325 326 328 329 330 330 330 The Stock Market 332 PREVIEW Investing in Stocks Common Stock Versus Preferred Stock How Stocks Are Sold Computing the Price of Common Stock The One-Period Valuation Model The Generalized Dividend Valuation Model The Gordon Growth Model Price Earnings Valuation Method How the Market Sets Security Prices Errors in Valuation Problems with Estimating Growth Problems with Estimating Risk Problems with Forecasting Dividends MINI-CASE Covid Impact on Stock Markets 332 333 333 334 338 338 339 340 341 342 343 343 344 344 345 06/07/23 11:01 AM 18 Contents in Detail Chapter 14 Chapter 15 A01_MISH9547_10_GE_FM.indd 18 Stock Market Indexes MINI-CASE History of the Dow Jones Industrial Average Buying Foreign Stocks Regulation of the Stock Market The Securities and Exchange Commission SUMMARY KEY TERMS QUESTIONS QUANTITATIVE PROBLEMS WEB EXERCISE 345 346 347 347 349 350 350 350 351 352 The Mortgage Markets 353 PREVIEW What Are Mortgages? Characteristics of the Residential Mortgage Mortgage Interest Rates CASE The Discount Point Decision Loan Terms Mortgage Loan Amortization Types of Mortgage Loans Insured and Conventional Mortgages Fixed- and Adjustable-Rate Mortgages Other Types of Mortgages Mortgage-Lending Institutions Loan Servicing E-FINANCE Borrowers Shop the Web for Mortgages Secondary Mortgage Market Securitization of Mortgages What Is a Mortgage-Backed Security? Types of Pass-Through Securities Subprime Mortgages and CDOs The Real Estate Bubble MINI-CASE Has Covid Led to a Housing Price Bubble? SUMMARY KEY TERMS QUESTIONS QUANTITATIVE PROBLEMS 353 354 355 355 356 358 359 360 360 361 361 363 364 365 365 366 366 368 369 370 371 371 371 372 372 The Foreign Exchange Market 374 PREVIEW Foreign Exchange Market What Are Foreign Exchange Rates? Why Are Exchange Rates Important? FOLLOWING THE FINANCIAL NEWS Foreign Exchange Rates How Is Foreign Exchange Traded? 374 375 375 375 376 376 06/07/23 11:01 AM Contents in Detail Chapter 15 Chapter 16 A01_MISH9547_10_GE_FM.indd 19 19 377 377 378 Exchange Rates in the Long Run Law of One Price Theory of Purchasing Power Parity Why the Theory of Purchasing Power Parity Cannot Fully Explain Exchange Rates Factors That Affect Exchange Rates in the Long Run Exchange Rates in the Short Run: A Supply and Demand Analysis Supply Curve for Domestic Assets Demand Curve for Domestic Assets Equilibrium in the Foreign Exchange Market Explaining Changes in Exchange Rates Shifts in the Demand for Domestic Assets Recap: Factors That Change the Exchange Rate CASE Effect of Changes in Interest Rates on the Equilibrium Exchange Rate CASE Brexit and the British Pound THE PRACTICING MANAGER Profiting from Foreign Exchange Forecasts SUMMARY KEY TERMS QUESTIONS QUANTITATIVE PROBLEMS WEB EXERCISES 378 380 381 382 383 383 383 384 387 389 390 391 392 392 393 393 394 Appendix: The Interest Parity Condition 395 Comparing Expected Returns on Domestic and Foreign Assets Interest Parity Condition 395 397 The International Financial System 399 PREVIEW Intervention in the Foreign Exchange Market Foreign Exchange Intervention and Reserves in the Banking System GLOBAL Variation in Central Banks’ Activism and Method of Intervention on Foreign Exchange Markets Unsterilized Intervention Sterilized Intervention Balance of Payments GLOBAL Rising Current Account Deficits in the EU Exchange Rate Regimes in the International Financial System Fixed Exchange Rate Regimes How a Fixed Exchange Rate Regime Works The Policy Trilemma Monetary Unions GLOBAL Will the Euro Survive? Currency Boards and Dollarization Speculative Attacks GLOBAL Argentina’s Currency Board Managed Float 399 400 400 401 402 402 403 405 405 405 406 408 409 410 410 410 411 411 06/07/23 11:01 AM 20 Contents in Detail GLOBAL Dollarization CASE The Foreign Exchange Crisis of September 1992 THE PRACTICING MANAGER Profiting from a Foreign Exchange Crisis CASE How Did China Accumulate Over $3 Trillion of International Reserves? Capital Controls Controls on Capital Outflows Controls on Capital Inflows The Role of the IMF Should the IMF Be an International Lender of Last Resort? SUMMARY KEY TERMS QUESTIONS QUANTITATIVE PROBLEMS WEB EXERCISE PART SIX THE FINANCIAL INSTITUTIONS INDUSTRY Chapter 17Banking and the Management of Financial Institutions PREVIEW The Bank Balance Sheet Liabilities Assets Basic Banking General Principles of Bank Management Liquidity Management and the Role of Reserves Asset Management Liability Management Capital Adequacy Management THE PRACTICING MANAGER Strategies for Managing Bank Capital CASE How a Capital Crunch Caused a Credit Crunch During the Global Financial Crisis Off-Balance-Sheet Activities Loan Sales Generation of Fee Income Trading Activities and Risk Management Techniques CONFLICTS OF INTEREST Barings, Daiwa, Sumitomo, Société Générale, and JPMorgan Chase: Rogue Traders and the Principal–Agent Problem Measuring Bank Performance Bank’s Income Statement Measures of Bank Performance Recent Trends in Bank Performance Measures SUMMARY KEY TERMS QUESTIONS QUANTITATIVE PROBLEMS A01_MISH9547_10_GE_FM.indd 20 412 412 414 415 415 415 416 416 417 417 418 418 419 419 420 420 421 421 423 424 427 427 430 431 432 434 435 435 436 436 436 437 438 438 440 441 443 444 444 444 06/07/23 11:01 AM Contents in Detail Chapter 18 Financial Regulation Chapter 19 A01_MISH9547_10_GE_FM.indd 21 21 446 PREVIEW Asymmetric Information as a Rationale for Financial Regulation Government Safety Net GLOBAL The Spread of Government Deposit Insurance Throughout the World: Is This a Good Thing? Types of Financial Regulation Restrictions on Asset Holdings Capital Requirements Prompt Corrective Action Financial Supervision: Chartering and Examination GLOBAL Where Is the Basel Accord Heading in a Post–Global Financial Crisis World? Assessment of Risk Management Disclosure Requirements Consumer Protection MINI-CASE Mark-to-Market Accounting and the Global Financial Crisis Restrictions on Competition MINI-CASE The Global Financial Crisis and Consumer Protection Regulation Macroprudential Versus Microprudential Supervision E-FINANCE Electronic Banking: New Challenges for Bank Regulation Summary GLOBAL International Financial Regulation The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 Dodd-Frank Too-Big-to-Fail and Future Regulation What Can Be Done About the Too-Big-to-Fail Problem? Other Issues for Future Regulation SUMMARY KEY TERMS QUESTIONS QUANTITATIVE PROBLEMS WEB APPENDIX 446 447 447 449 452 452 453 454 454 455 456 457 458 459 459 460 461 461 462 463 466 466 467 467 468 469 469 469 470 471 Banking Industry: Structure and Competition 472 PREVIEW Historical Development of the Banking System Multiple Regulatory Agencies Financial Innovation and the Growth of the Shadow Banking System Responses to Changes in Demand Conditions: Interest Rate Volatility Responses to Changes in Supply Conditions: Information Technology E-FINANCE Will Fintech Disrupt the Conventional Banking Sector? E-FINANCE Why Are Scandinavians So Far Ahead of Americans in Using Electronic Payments and Online Banking? E-FINANCE Sweden: The Leading Cashless Society Securitization and the Shadow Banking System Avoidance of Existing Regulations 472 473 475 475 476 477 479 480 481 482 484 06/07/23 11:01 AM 22 Contents in Detail MINI-CASE Bruce Bent and the Money Market Mutual Fund Panic of 2008 THE PRACTICING MANAGER Profiting from a New Financial Product: A Case Study of Treasury Strips Financial Innovation and the Decline of Traditional Banking Structure of the U.S. Banking Industry Restrictions on Branching Response to Branching Restrictions Bank Consolidation and Nationwide Banking E-FINANCE Information Technology and Bank Consolidation The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 What Will the Structure of the U.S. Banking Industry Look Like in the Future? Are Bank Consolidation and Nationwide Banking Good Things? Separation of the Banking and Other Financial Service Industries Erosion of Glass-Steagall The Gramm-Leach-Bliley Financial Services Modernization Act of 1999: Repeal of Glass-Steagall Implications for Financial Consolidation MINI-CASE The Global Financial Crisis and the Demise of Large, Free-Standing Investment Banks Separation of Banking and Other Financial Services Industries Throughout the World Thrift Industry Savings and Loan Associations Mutual Savings Banks Credit Unions International Banking Eurodollar Market Structure of U.S. Banking Overseas Foreign Banks in the United States SUMMARY KEY TERMS QUESTIONS Chapter 20 A01_MISH9547_10_GE_FM.indd 22 486 486 488 491 492 493 494 496 496 497 497 498 498 499 499 500 500 501 501 501 502 502 503 503 504 505 506 506 The Mutual Fund Industry 507 PREVIEW The Growth of Mutual Funds The First Mutual Funds Benefits of Mutual Funds Ownership of Mutual Funds Mutual Fund Structure Open- Versus Closed-End Funds CASE Calculating a Mutual Fund’s Net Asset Value Organizational Structure Investment Objective Classes Equity Funds Bond Funds Hybrid Funds Money Market Funds Index Funds 507 508 508 508 509 511 511 512 513 514 514 515 516 516 518 06/07/23 11:01 AM Contents in Detail Chapter 21 A01_MISH9547_10_GE_FM.indd 23 23 519 520 521 523 523 524 524 Fee Structure of Investment Funds Regulation of Mutual Funds Hedge Funds MINI-CASE The Long Term Capital Debacle Conflicts of Interest in the Mutual Fund Industry Sources of Conflicts of Interest Mutual Fund Abuses CONFLICTS OF INTEREST Many Mutual Funds Are Caught Ignoring Ethical Standards Government Response to Abuses CONFLICTS OF INTEREST SEC Survey Reports Mutual Fund Abuses Widespread SUMMARY KEY TERMS QUESTIONS QUANTITATIVE PROBLEMS WEB EXERCISE 525 526 526 527 528 528 528 530 Insurance Companies and Pension Funds 531 PREVIEW Insurance Companies Fundamentals of Insurance Adverse Selection and Moral Hazard in Insurance Selling Insurance MINI-CASE Insurance Agent: The Customer’s Ally Growth and Organization of Insurance Companies Types of Insurance Life Insurance Health Insurance MINI-CASE Updates to the Affordable Care Act Property and Casualty Insurance MINI-CASE Will Liability Issues Be a Roadblock to Driverless Cars? Insurance Regulation THE PRACTICING MANAGER Insurance Management Screening Risk-Based Premium Restrictive Provisions Prevention of Fraud Cancellation of Insurance Deductibles Coinsurance Limits on the Amount of Insurance Summary Credit Default Swaps CONFLICTS OF INTEREST The AIG Blowup Pensions CONFLICTS OF INTEREST The Subprime Financial Crisis and the Monoline Insurers 531 532 532 533 534 534 535 535 536 540 541 542 543 544 544 545 545 546 546 546 546 546 547 547 547 548 549 549 06/07/23 11:01 AM 24 Contents in Detail Types of Pensions Defined-Benefit Pension Plans Defined-Contribution Pension Plans Private and Public Pension Plans MINI-CASE Power to the Pensions Regulation of Pension Plans Employee Retirement Income Security Act Individual Retirement Plans The Future of Pension Funds SUMMARY KEY TERMS QUESTIONS QUANTITATIVE PROBLEMS Chapter 22Investment Banks, Security Brokers and Dealers, and Venture Capital Firms PREVIEW Investment Banks Background Underwriting Stocks and Bonds Equity Sales Mergers and Acquisitions MINI-CASE Twitter Uses Poison Pills to Drive Hard Bargain with Musk Securities Brokers and Dealers Brokerage Services MINI-CASE Example of Using the Limit-Order Book Securities Dealers Regulation of Securities Firms Relationship Between Securities Firms and Commercial Banks Private Equity Investment Venture Capital Firms Private Equity Buyouts Advantages to Private Equity Buyouts Life Cycle of the Private Equity Buyout SUMMARY KEY TERMS QUESTIONS QUANTITATIVE PROBLEMS 550 550 550 551 552 555 555 557 558 558 558 559 559 561 561 562 562 563 567 568 569 570 570 571 573 573 575 575 575 579 579 580 580 581 581 582 PART SEVEN THE MANAGEMENT OF FINANCIAL INSTITUTIONS Chapter 23 A01_MISH9547_10_GE_FM.indd 24 Risk Management in Financial Institutions 584 PREVIEW Managing Credit Risk Screening and Monitoring Long-Term Customer Relationships 584 585 585 586 06/07/23 11:01 AM Contents in Detail Chapter 24 A01_MISH9547_10_GE_FM.indd 25 25 Loan Commitments Collateral Compensating Balances Credit Rationing Managing Interest-Rate Risk Income Gap Analysis Duration Gap Analysis Example of a Nonbanking Financial Institution Some Problems with Income Gap and Duration Gap Analyses THE PRACTICING MANAGER Strategies for Managing Interest-Rate Risk SUMMARY KEY TERMS QUESTIONS QUANTITATIVE PROBLEMS WEB EXERCISE 587 587 588 588 589 590 592 597 599 600 601 601 601 602 604 Hedging with Financial Derivatives 605 PREVIEW Hedging Forward Markets Interest-Rate Forward Contracts THE PRACTICING MANAGER Hedging Interest-Rate Risk with Forward Contracts Pros and Cons of Forward Contracts Financial Futures Markets Financial Futures Contracts FOLLOWING THE FINANCIAL NEWS Financial Futures THE PRACTICING MANAGER Hedging with Financial Futures Organization of Trading in Financial Futures Markets Globalization of Financial Futures Markets Explaining the Success of Futures Markets MINI-CASE The Hunt Brothers and the Silver Crash THE PRACTICING MANAGER Hedging Foreign Exchange Risk with Forward and Futures Contracts Hedging Foreign Exchange Risk with Forward Contracts Hedging Foreign Exchange Risk with Futures Contracts Stock Index Futures Stock Index Futures Contracts FOLLOWING THE FINANCIAL NEWS Stock Index Futures THE PRACTICING MANAGER Hedging with Stock Index Futures Options Option Contracts Profits and Losses on Option and Futures Contracts Factors Affecting the Prices of Option Premiums Summary THE PRACTICING MANAGER Hedging with Futures Options 605 606 606 606 606 607 608 608 609 610 612 612 613 615 616 616 617 617 618 618 619 620 620 621 624 625 625 06/07/23 11:01 AM 26 Contents in Detail A01_MISH9547_10_GE_FM.indd 26 627 627 628 629 629 630 630 630 631 632 Interest-Rate Swaps Interest-Rate Swap Contracts THE PRACTICING MANAGER Hedging with Interest-Rate Swaps Advantages of Interest-Rate Swaps Disadvantages of Interest-Rate Swaps Financial Intermediaries in Interest-Rate Swaps Credit Derivatives Credit Options Credit Swaps Credit-Linked Notes CASE Lessons from the Global Financial Crisis: When Are Financial Derivatives Likely to Be a Worldwide Time Bomb? SUMMARY KEY TERMS QUESTIONS QUANTITATIVE PROBLEMS WEB EXERCISE WEB APPENDIX 632 633 634 634 635 637 637 Glossary G-1 Index I-1 Guide to Commonly Used Symbols S-1 06/07/23 11:01 AM Additional Materials Chapter 25 Chapter 26 Financial Crises in Emerging Market Economies W-1 PREVIEW Dynamics of Financial Crises in Emerging Market Economies Stage One: Initial Phase Stage Two: Currency Crisis Stage Three: Full-Fledged Financial Crisis CASE Crisis in South Korea, 1997–1998 Financial Liberalization/Globalization Mismanaged Perversion of the Financial Liberalization/Globalization Process: Chaebols and the South Korean Crisis Stock Market Decline and Failure of Firms Increase Uncertainty Adverse Selection and Moral Hazard Problems Worsen and the Economy Contracts Currency Crisis Ensues Final Stage: Currency Crisis Triggers Full-Fledged Financial Crisis Recovery Commences CASE The Argentine Financial Crisis, 2001–2002 Severe Fiscal Imbalances Adverse Selection and Moral Hazard Problems Worsen Bank Panic Begins Currency Crisis Ensues Currency Crisis Triggers Full-Fledged Financial Crisis Recovery Begins Preventing Emerging Market Financial Crises Beef Up Prudential Regulation and Supervision of Banks GLOBAL When an Advanced Economy Is Like an Emerging Market Economy: The Icelandic Financial Crisis of 2008 Encourage Disclosure and Market-Based Discipline Limit Currency Mismatch Sequence Financial Liberalization SUMMARY KEY TERMS QUESTIONS W-1 W-2 W-3 W-5 W-6 W-7 W-7 W-9 W-10 W-10 W-11 W-11 W-13 W-13 W-13 W-14 W-14 W-14 W-16 W-17 W-18 W-18 W-19 W-19 W-20 W-20 W-21 W-21 W-21 Savings Associations and Credit Unions W-22 PREVIEW Mutual Savings Banks Savings and Loan Associations Mutual Savings Banks and Savings and Loans Compared W-22 W-23 W-24 W-24 27 A01_MISH9547_10_GE_FM.indd 27 06/07/23 11:01 AM 28 Contents on the Web Chapter 27 A01_MISH9547_10_GE_FM.indd 28 W-25 W-26 W-27 W-27 W-28 Savings and Loans in Trouble: The Thrift Crisis Later Stages of the Crisis: Regulatory Forbearance Competitive Equality in Banking Act of 1987 Political Economy of the Savings and Loan Crisis Principal–Agent Problem for Regulators and Politicians CASE Principal–Agent Problem in Action: Charles Keating and the Lincoln Savings and Loan Scandal Savings and Loan Bailout: Financial Institutions Reform, Recovery, and Enforcement Act of 1989 The Savings and Loan Industry Today Number of Institutions S&L Size S&L Assets S&L Liabilities and Net Worth Capital Profitability and Health The Future of the Savings and Loan Industry Credit Unions History and Organization Sources of Funds Uses of Funds Advantages and Disadvantages of Credit Unions The Future of Credit Unions SUMMARY KEY TERMS QUESTIONS EXERCISE W-30 W-32 W-32 W-32 W-33 W-34 W-34 W-34 W-35 W-36 W-36 W-41 W-42 W-43 W-44 W-44 W-45 W-45 W-46 Finance Companies W-47 PREVIEW History of Finance Companies Purpose of Finance Companies Risk in Finance Companies Types of Finance Companies Business (Commercial) Finance Companies Consumer Finance Companies Sales Finance Companies Regulation of Finance Companies Finance Company Balance Sheet Assets Liabilities Income Finance Company Growth SUMMARY KEY TERMS QUESTIONS EXERCISE W-47 W-48 W-48 W-49 W-50 W-50 W-52 W-54 W-54 W-55 W-55 W-56 W-56 W-57 W-57 W-58 W-58 W-58 W-29 06/07/23 11:01 AM Contents on the Web 29 CHAPTER APPENDICES Chapter 4 Appendix 1: Models of Asset Pricing W-1 Chapter 4Appendix 2: Applying the Asset Market Approach to a Commodity Market: The Case of Gold W-11 Chapter 4 Appendix 3: Loanable Funds Framework W-15 Chapter 4Appendix 4: Supply and Demand in the Market for Money: The Liquidity Preference Framework W-19 Chapter 18 Appendix: Banking Crises Throughout the World W-31 Chapter 24 Appendix: More on Hedging with Financial Derivatives W-37 A01_MISH9547_10_GE_FM.indd 29 06/07/23 11:01 AM This page is intentionally left blank A01_MISH9547_10_GE_FM.indd 2 06/07/23 11:01 AM Preface A Note from Frederic Mishkin There has never been a more exciting time to teach financial markets and institutions. The recent worldwide financial crisis and the Covid pandemic cast a spotlight on the importance of financial institutions, financial markets, and monetary policy to the health of our economy. I experienced this firsthand when I served as a governor of the Federal Reserve System from 2006 to 2008, and in this book, Stan Eakins and I emphasize the rich tapestry of recent economic events to enliven the study of financial markets and institutions. Given what has happened, the study of financial markets and institutions has become particularly exciting. I hope that students reading this book will have as much fun learning from it as we have had in writing it. December 2022 What’s New in the Tenth Edition This text has undergone a major revision with new material in every part of the book, including updating of all data through 2022 whenever possible. However, it continues to retain the basic hallmarks that have made it the best-selling textbook on financial markets and institutions over the past nine editions. Compelling New Material on the Covid Pandemic The Covid pandemic that spread throughout the world in 2020 is one of the signature events of the twenty-first century. This has required the addition of many timely new sections, cases, and boxes throughout the book: • A new case that uses the analysis of the risk structure of interest rates to explain the effect of the pandemic on the Baa–Treasury spread (Chapter 5) • A new case on whether the Covid pandemic could have led to a financial crisis (Chapter 8) that shows how to apply the analysis of the dynamics of financial crises to explain when financial crises might occur in the future 31 A01_MISH9547_10_GE_FM.indd 31 06/07/23 11:01 AM 32 Preface • An update to the section on nonconventional monetary policy tools and quantitative easing (Chapter 10) to discuss how they were used during the Covid pandemic • An updated “Inside the Fed” box on Fed lending facilities during the Covid crisis (Chapter 10) • A new “Mini-Case” box on how Covid led to money market fund withdrawals (Chapter 11) • A new case on Covid’s impact on the stock market that illustrates how stock market prices are affected by shocks like the Covid pandemic (Chapter 13) • A new “Mini-Case” box on whether Covid has led to a housing price bubble (Chapter 14) New Material on Financial Markets and Monetary Policy In the aftermath of the global financial and Covid crises, there have been major changes in financial markets and the way central banks conduct monetary policy. This has involved the following new material: • A new case on the effects of the Trump tax cuts on bond interest rates (Chapter 5) that shows how supply and demand analysis of the bond market can be used to explain the effect of taxes on different interest rates • An update to the section on nonconventional monetary policy tools and quantitative easing (Chapter 10) to discuss how they were used during the Covid pandemic • A new “Inside the Fed” box on the Fed’s new monetary policy strategy, announced in August 2020 (Chapter 10), which involves a modification of inflation targeting • A new case that uses the supply and demand analysis of the foreign exchange market to explain the dramatic effect that Brexit had on the British pound (Chapter 15) • A new “E-Finance” box on Sweden as a leading example of a cashless society (Chapter 19) • A new “Mini-Case” box on updates to the Affordable Care Act (Chapter 21) • A new “Mini-Case” box on whether liability issues will be a roadblock to driverless cars (Chapter 21) • A new “Mini-Case” box on how Twitter used a poison pill to drive a hard bargain with Elon Musk (Chapter 22) Additional Appendices The additional material for the book include the following appendices: Chapter 4: Models of Asset Pricing Chapter 4: Applying the Asset Market Approach to a Commodity Market: The Case of Gold A01_MISH9547_10_GE_FM.indd 32 06/07/23 11:01 AM Preface 33 Chapter 4: Loanable Funds Framework Chapter 4: Supply and Demand in the Market for Money: The Liquidity Preference Framework Chapter 18: Banking Crises Throughout the World Chapter 24: More on Hedging with Financial Derivatives Instructors can either use these appendices in class to supplement the material in the textbook or recommend them to students who want to expand their knowledge of the financial markets and institutions field. Hallmarks Although this text has undergone a major revision, it retains the basic hallmarks that make it the best-selling textbook on financial markets and institutions. The tenth edition of Financial Markets and Institutions is a practical introduction to the workings of today’s financial markets and institutions. Moving beyond the descriptions and definitions provided by other textbooks in the field, Financial Markets and Institutions encourages students to understand the connection between the theoretical concepts and their real-world applications. By enhancing students’ analytical abilities and concrete problem-solving skills, this textbook prepares students for successful careers in the financial services industry or successful interactions with financial institutions, whatever their jobs. To prepare students for their future careers, Financial Markets and Institutions provides the following features: • A unifying analytic framework that uses a few basic principles to organize students’ thinking. These principles include: Asymmetric information (agency) problems Conflicts of interest Transaction costs Supply and demand Asset market equilibrium Efficient markets Measurement and management of risk • “The Practicing Manager” sections include nearly 20 hands-on applications that emphasize the financial practitioner’s approach to financial markets and institutions. • A careful step-by-step development of models enables students to master the material more easily. • A high degree of flexibility allows professors to teach the course in the manner they prefer. • International perspectives are completely integrated throughout the text. • “Following the Financial News” is a feature that encourages the reading of a financial newspaper. • Numerous cases increase students’ interest by applying theory to real-world data and examples. A01_MISH9547_10_GE_FM.indd 33 06/07/23 11:01 AM 34 Preface • The text focuses on the impact of electronic (computer and telecommunications) technology on the financial system. The text makes extensive use of the Internet with Web exercises, Web sources for charts and tables, and Web references in the margins. It also features special “E-Finance” boxes that explain how changes in technology have affected financial markets and institutions. Flexibility There are as many ways to teach financial markets and institutions as there are instructors. Thus, there is a great need to make a textbook flexible in order to satisfy the diverse needs of instructors, and that has been a primary objective in writing this book. This textbook achieves this flexibility in the following ways: • Core chapters provide the basic analysis used throughout the book, and other chapters or sections of chapters can be assigned or omitted according to instructor preferences. For example, Chapter 2 introduces the financial system and basic concepts such as transaction costs, adverse selection, and moral hazard. After covering Chapter 2, an instructor can decide to teach a more detailed treatment of financial structure and financial crises using chapters in Part 3 of the text, or cover specific chapters on financial markets or financial institutions in Parts 4 or 5 of the text, or the instructor can skip these chapters and take any of a number of different paths. • The approach to internationalizing the text using separate, marked international sections within chapters and separate chapters on the foreign exchange market and the international monetary system is comprehensive yet flexible. Although many instructors will teach all the international material, others will choose not to. Instructors who want less emphasis on international topics can easily skip Chapter 15 (on the foreign exchange market) and Chapter 16 (on the international financial system). • “The Practicing Manager” applications, as well as Part 7 on the management of financial institutions, are self-contained and so can be skipped without loss of continuity. Thus, an instructor wishing to teach a less managerially oriented course, who might want to focus on public policy issues, will have no trouble doing so. Alternatively, Part 7 can be taught earlier in the course, immediately after Chapter 17 on bank management. The course outlines listed next for a semester teaching schedule illustrate how this book can be used for courses with a different emphasis. More detailed information about how the text can offer flexibility in your course is available in the Instructor’s Manual. Financial markets and institutions emphasis: Chapters 1–5, 7–8, 11–13, 17–19, and a choice of five other text chapters Financial markets and institutions with international emphasis: Chapters 1–5, 7–9, 11–13, 15–19, and a choice of three other text chapters Managerial emphasis: Chapters 1–5, 17–19, 23–24, and a choice of eight other text chapters Public policy emphasis: Chapters 1–5, 7–10, 17–18, and a choice of seven other text chapters A01_MISH9547_10_GE_FM.indd 34 06/07/23 11:01 AM Preface 35 Pedagogical Aids A textbook must be a solid motivational tool. To this end, we have incorporated a wide variety of pedagogical features. 1. Chapter Previews at the beginning of each chapter tell students where the chapter is heading, why specific topics are important, and how they relate to other topics in the book. 2. Cases demonstrate how the analysis in the book can be used to explain many important real-world situations. 3. “The Practicing Manager” is a set of special cases that introduce students to real-world problems that managers of financial institutions have to solve. 4. Numerical Examples guide students through solutions to financial problems using formulas, time lines, and calculator key strokes. 5. “Following the Financial News” boxes introduce students to relevant news articles and data that are reported daily in financial news sources and explain how to read them. 6. “Inside the Fed” boxes give students a feel for what is important in the operation and structure of the Federal Reserve System. 7. “Global” boxes include interesting material with an international focus. 8. “E-Finance” boxes relate how changes in technology have affected financial markets and institutions. 9. “Conflicts of Interest” boxes outline conflicts of interest in different financial service industries. 10. “Mini-Case” boxes highlight dramatic historical episodes or apply the theory to the data. 11. Summary Tables are useful study aids for reviewing material. 12. Key Statements are important points that are set in boldface type so that students can easily find them for later reference. 13. Graphs with captions, numbering over 100, help students understand the interrelationship of the variables plotted and the principles of analysis. 14. Summaries at the end of each chapter list the chapter’s main points. 15. Key Terms are important words or phrases that appear in boldface type when they are defined for the first time and are listed at the end of each chapter. 16. End-of-Chapter Questions, numbering nearly 400, help students learn the subject matter by applying economic concepts and feature a special class of questions that students find particularly relevant, titled “Predicting the Future.” 17. End-of-Chapter Quantitative Problems, numbering over 200, help students to develop their quantitative skills. 18. Web Exercises encourage students to collect information from online sources or use online resources to enhance their learning experience. 19. Web Sources report the URL source of the data used to create the many tables and charts. 20. Marginal Web References point the student to Web sites that provide information or data that supplement the text material. A01_MISH9547_10_GE_FM.indd 35 06/07/23 11:01 AM 36 Preface 21. Glossary at the back of the book defines all the key terms. 22. Full Solutions to the Questions and Quantitative Problems appear in the Instructor’s Manual and on the Instructor’s Resource Center at https:// www.pearson.com/en-gb.html. Professors have the flexibility to share the solutions with their students as they see fit. Supplementary Materials The tenth edition of Financial Markets and Institutions includes the most comprehensive program of supplementary materials of any textbook in its field. These items are available to qualified domestic adopters but in some cases may not be available to international adopters. These include the following items: For the Professor The demands for good teaching at business schools have increased dramatically in recent years. To meet these demands, the tenth edition of Financial Markets and Institutions includes the most comprehensive program of supplementary materials of any textbook in its field that should make teaching the course substantially easier. These resources are available at https://www.pearson.com/en-gb.html. 1. Instructor’s Manual: This manual, prepared by the authors, includes chapter outlines, overviews, teaching tips, and complete solutions to questions and problems in the text. 2. PowerPoint: Prepared by John Banko (University of Florida). The presentation, which contains lecture notes and the complete set of figures and tables from the textbook, contains more than 1,000 slides that comprehensively outline the major points covered in the text. 3. Test Bank: Updated and revised for the tenth edition, the Test Bank comprises over 2,500 multiple-choice, true-false, and essay questions. All of the questions from the Test Bank are available in computerized format for use in the TestGen software. The TestGen software is available for both Windows and Macintosh systems. A01_MISH9547_10_GE_FM.indd 36 06/07/23 11:01 AM Preface 37 Acknowledgments As always in so large a project, there are many people to thank. Our special gratitude goes to Bruce Kaplan, former economics editor at HarperCollins; Donna Battista, Adrienne D’Ambrosio, and Christina Masturzo, our former finance editors; Chris DeJohn, our current editor at Pearson; and Jane Tufts and Amy Fleischer, our former development editors. We also have been assisted by comments from my colleagues at Columbia, my students, and Aaron Jackson of Bentley University, who carefully proofread the entire manuscript. In addition, we have been guided in this edition and its predecessors by the thoughtful comments of outside reviewers and correspondents. Their feedback has made this a better book. In particular, we thank: Ibrahim J. Affanen, Indiana University of Pennsylvania Vikas Agarwal, Georgia State University Senay Agca, George Washington University Aigbe Akhigbe, University of Akron Ronald Anderson, University of Nevada–Las Vegas Bala G. Arshanapalli, Indiana University Northwest Christopher Bain, Ohio State University James C. Baker, Kent State University John Banko, University of Central Florida Mounther H. Barakat, University of Houston–Clear Lake Joel Barber, Florida International University Thomas M. Barnes, Alfred University Marco Bassetto, Northwestern University Dallas R. Blevins, University of Montevallo Matej Blusko, University of Georgia Paul J. Bolster, Northeastern University Lowell Boudreaux, Texas A&M University–Galveston Deanne Butchey, Florida International University Mitch Charklewicz, Central Connecticut State University Yea-Mow Chen, San Francisco State University N. K. Chidambaran, Tulane University Wan-Jiun Paul Chiou, Shippensburg University Jeffrey A. Clark, Florida State University Robert Bruce Cochran, San Jose State University William Colclough, University of Wisconsin–La Crosse James Conover, University of North Texas Elizabeth Cooperman, University of Baltimore Brian Davis, Pennsylvania State University Carl Davison, Mississippi State University Cris de la Torre, University of Northern Colorado Erik Devos, Ohio University at SUNY Binghamton David Dieterle, Walsh College Alan Durell, Dartmouth College Franklin R. Edwards, Columbia University Marty Eichenbaum, Northwestern University Elyas Elyasiani, Temple University Edward C. Erickson, California State University–Stanislaus Kenneth Fah, Ohio Dominican College J. Howard Finch, Florida Gulf Coast University E. Bruce Fredrikson, Syracuse University Cheryl Frohlich, University of North Florida James Gatti, University of Vermont Steven Gattuso, Canisius College Paul Girma, State University of New York–New Paltz Susan Glanz, St. John’s University A01_MISH9547_10_GE_FM.indd 37 Gary Gray, Pennsylvania State University Wei Guan, University of South Florida–St. Petersburg Charles Guez, University of Houston Beverly L. Hadaway, University of Texas John A. Halloran, University of Notre Dame Billie J. Hamilton, East Carolina University John H. Hand, Auburn University Jeffery Heinfeldt, Ohio Northern University Tahereh Hojjat, DeSales University Don P. Holdren, Marshall University Adora Holstein, Robert Morris College Sylvia C. Hudgins, Old Dominion University Jerry G. Hunt, East Carolina University Boulis Ibrahim, Heroit-Watt University William E. Jackson, University of North Carolina–Chapel Hill Joe James, Sam Houston State University Melvin H. Jameson, University of Nevada–Las Vegas Kurt Jessewein, Texas A&M International University Jack Jordan, Seton Hall University Tejendra Kalia, Worcester State College Taeho Kim, Thunderbird: The American Graduate School of International Management Taewon Kim, California State University–Los Angeles Elinda Kiss, University of Maryland Glen A. Larsen, Jr., University of Tulsa James E. Larsen, Wright State University Rick LeCompte, Wichita State University Baeyong Lee, Fayetteville State University Boyden E. Lee, New Mexico State University Adam Lei, Midwestern State University Kartono Liano, Mississippi State University Hao Lin, California State University, Sacramento John Litvan, Southwest Missouri State University Richard A. Lord, Georgia College Robert L. Losey, American University Anthony Loviscek, Seton Hall University James Lynch, Robert Morris College Judy E. Maese, New Mexico State University William Mahnic, Case Western Reserve University Inayat Mangla, Western Michigan University William Marcum, Wake Forest University David A. Martin, Albright College Lanny Martindale, Texas A&M University Joseph S. Mascia, Adelphi University Khalid Metabdin, College of St. Rose 06/07/23 11:01 AM 38 Preface Robert McLeod, University of Alabama David Milton, Bentley College A. H. Moini, University of Wisconsin–Whitewater Russell Morris, Johns Hopkins University Chee Ng, Fairleigh Dickinson University Srinivas Nippani, Texas A&M Commerce Terry Nixon, Indiana University William E. O’Connell, Jr., The College of William and Mary Masao Ogaki, Ohio State University Sam Olesky, University of California–Berkeley Evren Ors, Southern Illinois University Coleen C. Pantalone, Northeastern University Scott Pardee, University of Chicago Ohaness Paskelian, University of Houston James Peters, Fairleigh Dickinson University Fred Puritz, State University of New York–Oneonta Mahmud Rahman, Eastern Michigan University Anoop Rai, Hofstra University Mitchell Ratner, Rider University David Reps, Pace University–Westchester Terry Richardson, Bowling Green State University Harvey Rosenblum, Southern Methodist University Jack Rubens, Bryant College Charles B. Ruscher, James Madison University William Sackley, University of Southern Mississippi Kevin Salyer, University of California–Davis Siamack Shojai, Manhattan College Javadi Siamak, Oklahoma University Donald Smith, Boston University Kenneth Smith, University of Texas–Dallas Sonya Williams Stanton, Ohio State University Michael Sullivan, Florida International University Rick Swasey, Northeastern University Anjan Thackor, University of Michigan Janet M. Todd, University of Delaware James Tripp, Western Illinois University Carlos Ulibarri, Washington State University Emre Unlu, University of Nebraska–Lincoln John Wagster, Wayne State University Bruce Watson, Wellesley College David A. Whidbee, California State University–Sacramento Arthur J. Wilson, George Washington University Shee Q. Wong, University of Minnesota–Duluth Criss G. Woodruff, Radford University Tong Yu, University of Rhode Island Dave Zalewski, Providence College Finally, I want to thank my wife, Sally, my son, Matthew, and my daughter, Laura, who provide me with a warm and happy environment that enables me to do my work, and my father, Sidney, now deceased, who a long time ago put me on the path that led to this book. Frederic S. Mishkin I would like to thank Rick Mishkin for his excellent comments on my contributions. By working with Rick on this text, not only have I gained greater skill as a writer, but I have also gained a friend. I would also like to thank my wife, Laurie, for patiently reading each draft of this manuscript and for helping make this my best work. Through the years, her help and support have made this aspect of my career possible. Stanley G. Eakins Global Edition Acknowledgments We want to thank the following people for their contributions: Olivier Butzbach, University of Campania “Luigi Vanvitelli” Anita Mirchandani, Canadian University Dubai Karan Vishwanath, University of London We would also like to thank the following people for reviewing the Global Edition and sharing their insightful comments and suggestions: Zheng Chris Cao, Aston University Hameedah Sayani, Iqra University Anh Tran, Monash University A01_MISH9547_10_GE_FM.indd 38 06/07/23 11:01 AM About the Authors Frederic S. Mishkin is the Alfred Lerner Professor of Banking and Financial Institutions at the Graduate School of Business, Columbia University. From September 2006 to August 2008, he was a member (governor) of the Board of Governors of the Federal Reserve System. He is also a research associate at the National Bureau of Economic Research and past president of the Eastern Economics Association. Since receiving his Ph.D. from the Massachusetts Institute of Technology in 1976, he has taught at the University of Chicago, Northwestern University, Princeton University, and Columbia University. He has also received an honorary professorship from the People’s (Renmin) University of China. From 1994 to 1997, he was executive vice president and director of research at the Federal Reserve Bank of New York and an associate economist of the Federal Open Market Committee of the Federal Reserve System. Professor Mishkin’s research focuses on monetary policy and its impact on financial markets and the aggregate economy. He is the author of more than 20 books, including Macroeconomics: Policy and Practice, Second Edition (Pearson, 2015); The Economics of Money, Banking and Financial Markets, Eleventh Edition (Pearson, 2016); Monetary Policy Strategy (MIT Press, 2007); The Next Great Globalization: How Disadvantaged Nations Can Harness Their Financial Systems to Get Rich (Princeton University Press, 2006); Inflation Targeting: Lessons from the International Experience (Princeton University Press, 1999); Money, Interest Rates, and Inflation (Edward Elgar, 1993); and A Rational Expectations Approach to Macroeconometrics: Testing Policy Ineffectiveness and Efficient Markets Models (University of Chicago Press, 1983). In addition, he has published more than 200 articles in such journals as American Economic Review, Journal of Political Economy, Econometrica, Quarterly Journal of Economics, Journal of Finance, Journal of Applied Econometrics, Journal of Economic Perspectives, and Journal of Money Credit and Banking. Professor Mishkin has served on the editorial board of the American Economic Review and has been an associate editor at the Journal of Business and Economic Statistics, Journal of Applied Econometrics, Journal of Economic Perspectives, Journal of Money, Credit and Banking, and Journal of International Money and Finance; he also served as the editor of the Federal Reserve Bank of New York’s Economic Policy Review. He is currently an associate editor (member of the editorial board) at six academic journals, including International Finance; Finance India; Emerging Markets, Finance and Trade; Review of Development Finance, Borsa Economic Review, and PSU Research Review. He has served as a senior fellow at the Federal Deposit Insurance Corporation’s Center for Banking Research and has been a consultant to the Board of Governors of the Federal Reserve System, the World Bank, and the International Monetary Fund, as well as to many central banks throughout the world. He was also a member of the International Advisory Board to the Financial Supervisory Service of South Korea and an adviser to the Institute for Monetary and Economic Research at the Bank of Korea. He was a member of the Economic Advisory Panel and the Monetary Policy Advisory Panel of the Federal Reserve Bank of New York. Stanley G. Eakins has notable experience as a financial practitioner, serving as vice president and comptroller at the First National Bank of Fairbanks and as a commercial and real estate loan officer. A founder of the Denali Title and Escrow Agency, a title insurance company in Fairbanks, Alaska, he also ran the operations side of a bank and was the chief finance officer for a multimillion-dollar construction and development company. Professor Eakins received his Ph.D. from Arizona State University. He was the Dean for the College of Business at East Carolina University. His research is focused primarily on the role of institutions in corporate control and how they influence investment practices. He is also interested in integrating multimedia tools into the learning environment and has received grants from East Carolina University in support of this work. A contributor to journals such as the Quarterly Journal of Business and Economics, the Journal of Financial Research, and the International Review of Financial Analysis, Professor Eakins is also the author of Corporate Finance 2.1 from FlatWorld Knowledge. 39 A01_MISH9547_10_GE_FM.indd 39 06/07/23 11:01 AM This page is intentionally left blank A01_MISH9547_10_GE_FM.indd 2 06/07/23 11:01 AM 1 CHAPTER PART 1 INTRODUCTION Why Study Financial Markets and Institutions? PREVIEW On the evening news you have just heard that the mutual funds, and other institutions) work. Financial bond market has been booming. Does this mean that markets and institutions not only affect your everyday interest rates will fall so that it is easier for you to life but also involve huge flows of funds—trillions finance the purchase of a new computer system for of dollars—throughout our economy, which in turn your small retail business? Will the economy improve affect business profits, the production of goods in the future so that it is a good time to build a new and services, and even the economic well-being building or add to the one you are in? Should you try of countries other than the United States. What to raise funds by issuing stocks or bonds or instead happens to financial markets and institutions is of go to the bank for a loan? If you import goods from great concern to politicians and can even have a abroad, should you be concerned that they will 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 questions understanding of many exciting issues. In this by examining how financial markets (such as chapter we provide a road map of the book by those for bonds, stocks, and foreign exchange) and outlining these exciting issues and exploring why financial institutions (banks, insurance companies, they are worth studying. 41 M01_MISH9547_10_GE_C01.indd 41 26/06/23 7:26 AM 42 PART 1 Introduction 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 https://fred.stlouisfed.org/ 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 and rose to 5% by 2007, only to fall close to zero from 2008 to 2021. Starting in 2022, the three-month Treasury bill rate started to rise, climbing to well above zero. Because different interest rates have a tendency to move in unison, economists frequently lump interest rates together and refer to “the” interest rate. 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. M01_MISH9547_10_GE_C01.indd 42 26/06/23 7:26 AM Chapter 1 Why Study Financial Markets and Institutions? 43 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 2020 FIGURE 1.1 Interest Rates on Selected Bonds, 1950–2022 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. As Figure 1.1 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 (medium-quality) 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. M01_MISH9547_10_GE_C01.indd 43 26/06/23 7:26 AM 44 PART 1 Introduction Dow Jones Industrial Average 40,000 38,000 36,000 34,000 32,000 30,000 28,000 26,000 24,000 22,000 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 2020 FIGURE 1.2 Stock Prices as Measured by the Dow Jones Industrial Average, 1950–2022 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 28,000 level in 2020. The Covid pandemic then led to a stock market crash in March 2020, with the DJIA falling by over 35%, only to recover sharply thereafter. 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 this M01_MISH9547_10_GE_C01.indd 44 26/06/23 7:26 AM Chapter 1 Why Study Financial Markets and Institutions? 45 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 2022 (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 2022. 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, 1995–2001, and 2014–2022 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 Index (March 1973 = 100) 150 135 120 105 90 75 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 FIGURE 1.3 Exchange Rate of the U.S. Dollar, 1973–2022 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/DTWEXBGS. M01_MISH9547_10_GE_C01.indd 45 26/06/23 7:26 AM 46 PART 1 Introduction the opposite effect: It 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. M01_MISH9547_10_GE_C01.indd 46 26/06/23 7:26 AM Chapter 1 Why Study Financial Markets and Institutions? 47 entral Banks and the Conduct C of Monetary Policy GO ONLINE www.federalreserve.gov MINI-CASE 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 Are Bitcoin or Other Cryptocurrencies Money? Cryptocurrencies are a form of electronic cash that use cryptography to make financial transactions secure. Cryptocurrencies are not controlled by a single entity like a central bank, but rather are created in a decentralized fashion by users who generate new units of the cryptocurrency when they use their computing power to verify and process transactions, a process referred to as “mining.” Bitcoin is currently the cryptocurrency with the largest amount outstanding, but other cryptocurrencies, such as Ethereum, Ripple, Bitcoin Cash, and EOS, are widely used. There has been a lot of hype about cryptocurrencies, including even super-expensive Super Bowl ads. Some tech enthusiasts have characterized Bitcoin and other cryptocurrencies as the money of the future. But do these cryptocurrencies satisfy the key functions of money: a medium of exchange, a unit of account, and a store of value? A medium of exchange is an instrument that can be used to pay for goods and services. Cryptocurrencies certainly function well as a medium of exchange. They have two features that make them attractive for conducting transactions. First, the transaction fees are substantially lower than those associated with credit cards and debit cards, and second, transactions made with cryptocurrencies can be made anonymously, which is very attractive to those who want to preserve their privacy. The second function of money is that it is a unit of account, that is, it can be used to measure value in an economy. For example, in the United States, all goods and services are measured in terms of dollars. Cryptocurrencies are a poor measure of value of goods and services because they undergo huge fluctuations in value. For example, the price of Bitcoin has been extremely volatile, with its volatility estimated to be over seven times that of the price of gold and over M01_MISH9547_10_GE_C01.indd 47 eight times that of stock market indexes such as the S&P 500. For example, on March 12, 2020, Bitcoin had a price of just under $5,000, and then it reached a peak on November 9, 2021 of over $65,000, only to fall below $25,000 by July 2022. Prices of goods and services in terms of cryptocurrency therefore have massive fluctuations from day to day. Not surprisingly, no cryptocurrency has become a unit of account. Almost no one quotes the prices of their goods or services in terms of Bitcoin or any other cryptocurrency. The third function of money is as a store of value, a repository of purchasing power over time. A store of value is used to save purchasing power from the time income is received until the time it is spent. The high volatility of the value of cryptocurrencies also means that they do not function well as a store of value; they are just too risky. Bitcoin and other cryptocurrencies do not satisfy two of the three key functions of money. Despite the hype, our understanding of the functions of money strongly suggests that cryptocurrencies will not be the money of the future. Furthermore, Bitcoin and other cryptocurrencies, which are hard to trace, are used by criminal enterprises operating on the so-called dark web, Web sites that are hard to find by browsing. Governments may therefore restrict the use of these cryptocurrencies in the future. China has already outlawed the use of Bitcoin as a currency. This should give you pause about how good of an investment cryptocurrencies are likely to be. However, some cryptocurrency technology, which enables users to conduct electronic transactions cheaply, may become a feature of future electronic payment systems. Indeed, central banks are contemplating issuing their own forms of digital currencies that will have many features of cryptocurrencies but will be fixed in value to a unit of account, such as the U.S. dollar. 26/06/23 7:26 AM 48 PART 1 Introduction 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 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. M01_MISH9547_10_GE_C01.indd 48 26/06/23 7:26 AM Chapter 1 Why Study Financial Markets and Institutions? 49 Managing Risk in Financial Institutions In the past 10 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 day-to-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. 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. M01_MISH9547_10_GE_C01.indd 49 26/06/23 7:26 AM 50 PART 1 Introduction 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 of sites related to the material being discussed. Visit these sites to further explore a topic you find of particular interest. Collecting and Graphing Data The following Web exercise is especially important because it demonstrates how to export data from a Web site 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 and whenever you want to collect data from the Web and apply it to particular situations. M01_MISH9547_10_GE_C01.indd 50 26/06/23 7:26 AM Chapter 1 Why Study Financial Markets and Institutions? 51 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 2022 to the present. Your employers are initially interested in determining the relationship between longand s hort-term 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 https://fred. stlouisfed.org/, a terrific resource for economic data. In the “Search FRED data” box, type in “10-year constant maturity rate,” click ENTER and then click on “Market Yield on U.S. Treasury Securities at 10-year Constant Maturity Quoted on an Investment Basis.” 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. Now click on “Edit Graph” and then click on modify frequency and choose “Monthly.” Now choose “Add Line” at the top of the edit graph window; type in “1-year” and click on “Market Yield on U.S. Treasury Securities at 1-Year Constant Maturity.” Then click on the “Add data series” box. Click on “Monthly” under “Modify frequency” and click on the X on the top right to return to the graph. Change the beginning observation date to 2022, January 1. Click on “Download” and then on “Excel (data)” from the dropdown. Click on “fedgraph.xls” at the bottom and you will now see a table similar to Figure 1.4. 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 three columns (observation date plus two columns of interest-rate data) you just created in Excel, including FIGURE 1.4 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. M01_MISH9547_10_GE_C01.indd 51 26/06/23 7:26 AM 52 PART 1 Introduction FIGURE 1.5 Excel Graph of Interest-Data Source: Used with permission from Microsoft Corporation. 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 2022 to the present and click “OK.” In the same row as you put the label “Standard Deviation,” 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 2022 to the present and click “OK.” You should now see a data representation similar to Figure 1.5. 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. M01_MISH9547_10_GE_C01.indd 52 26/06/23 7:26 AM Chapter 1 Why Study Financial Markets and Institutions? 53 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). 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. 4. Understanding how financial institutions are managed is important 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 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. KEY TERMS financial crises, p. 46 financial innovation, p. 48 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 assets, p. 42 banks, p. 48 bond, p. 42 central bank, p. 47 common stock, p. 43 e-finance, p. 48 Federal Reserve System (the Fed), p. 47 money (money supply), p. 47 security, p. 42 stock, p. 43 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. 9. Discuss the role of banks as financial institutions that fuel the economic growth of a nation. 2. When interest rates rise, how might businesses and consumers change their economic behavior? 10. How can fluctuations in a foreign exchange rate affect domestic and foreign consumption? Looking at Figure 1.3, briefly discuss how the U.S. dollar exchange rates behave. 3. When interest rates fall, how might financial institutions like banks benefit? 11. How do you think financial institutions help financial markets to work? 4. Why is it that economists often refer to “the” interest rate, while there are many interest rates in any economy? 12. How can monetary policies created by a central bank affect financial markets and financial institutions? 5. Why are stock newsworthy? 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? market conditions usually 6. Explain the main difference between a bond and a common stock. 7. How can a decline in the value of the pound sterling affect German consumers in the Eurozone? 14. What types of risks do financial institutions face? 15. Why is there a need to manage risk in financial institutions? 8. How does an increase in the value of the U.S. dollar affect businesses in the Eurozone? M01_MISH9547_10_GE_C01.indd 53 26/06/23 7:26 AM 54 PART 1 Introduction Q U A N T I TAT I V E P R O B L E M 1. The following table lists the foreign exchange rates between the U.S. dollar (USD) and the euro (EUR) during February. Date USD per EUR 2/15 1.369300 2/16 1.369300 Date USD per EUR 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 into euros? Which day would have been the worst? What would the difference be in euros? 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 51–52 as a guide. Go to https://fred. stlouisfed.org/ and type in “Dow Jones Industrial Average” in the “Search Fred data” box, and then click on “Dow Jones Industrial Average.” On the far right select “Edit Graph.” Select “Monthly” in “Modify Frequency.” 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. 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 change is forecast for the next six months? a. Using the method presented in this chapter, move the data into an Excel spreadsheet. M01_MISH9547_10_GE_C01.indd 54 26/06/23 7:26 AM 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 M02_MISH9547_10_GE_C02.indd 55 30/06/23 2:49 PM 56 PART 1 Introduction 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 (IOUs or debts) for the individual or firm that sells (issues) them. 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. M02_MISH9547_10_GE_C02.indd 56 30/06/23 2:49 PM Chapter 2 Overview of the Financial System 57 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 global financial crisis from 2007 to 2009, 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 young people to buy what they need and can eventually afford without forcing them M02_MISH9547_10_GE_C02.indd 57 30/06/23 2:49 PM 58 PART 1 Introduction 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 $80 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 sometimes larger than the size of the equities market: At the end of 2021, the value of debt instruments was $56.1 trillion, while the value of equities was $80.1 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. M02_MISH9547_10_GE_C02.indd 58 30/06/23 2:49 PM 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. M02_MISH9547_10_GE_C02.indd 59 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-the-counter (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 30/06/23 2:49 PM 60 PART 1 Introduction dealers establish a “market” in these securities by standing ready to buy and sell 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. M02_MISH9547_10_GE_C02.indd 60 30/06/23 2:49 PM 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 10 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 to return 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. 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 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 short-term 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 M02_MISH9547_10_GE_C02.indd 61 30/06/23 2:49 PM 62 PART 1 Introduction sold outside the countries that have adopted the euro. In fact, most Eurobonds 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. World Stock Markets GO ONLINE www.stockcharts.com This site contains historical stock market index charts for many countries around the world. GO ONLINE https://finance.yahoo.com/ Access major world stock indexes, with charts, news, and components. 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 borrower-spenders. 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. M02_MISH9547_10_GE_C02.indd 62 30/06/23 2:49 PM Chapter 2 Overview of the Financial System 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. FTSE 100 An index of the 100 most highly capitalized U.K. 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. 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. Strait Times An index of the largest 30 companies traded on the Singapore Exchange. GLOBAL S&P 500 An index of 500 of the largest companies traded in the United States maintained by Standard & Poor’s. 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.1 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. 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 money, but to protect your investment, you have to hire a lawyer to write up the 1 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. M02_MISH9547_10_GE_C02.indd 63 30/06/23 2:49 PM 64 PART 1 Introduction 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. M02_MISH9547_10_GE_C02.indd 64 30/06/23 2:49 PM Chapter 2 Overview of the Financial System 65 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.2 Adverse selection is the problem created by asymmetric information before the transaction occurs. Adverse selection occurs when one party to a transaction has information about a hidden characteristic and takes economic advantage of this information by making an agreement (transaction) with less informed parties. In financial markets, adverse selection occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome—the bad credit risks—actively seek out a loan and are thus more 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 occurs when an informed party takes a hidden (unobserved) action that harms the less informed party. In financial markets, it 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 2 Asymmetric information and the adverse selection and moral hazard concepts are also crucial problems for the insurance industry. See Chapter 21. M02_MISH9547_10_GE_C02.indd 65 30/06/23 2:49 PM 66 PART 1 Introduction 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 tells you he needs the money to purchase a computer so that he can set up a business typing students’ term papers. Once you have made the loan, however, Uncle Melvin is more likely to secretly 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 lendersavers 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 M02_MISH9547_10_GE_C02.indd 66 30/06/23 2:49 PM Chapter 2 Overview of the Financial System 67 investment bank, for example, can evaluate how good a credit risk a corporation is 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 2000, 2010, 2020 and 2021. 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 4,000 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, which number approximately 600, 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 M02_MISH9547_10_GE_C02.indd 67 30/06/23 2:49 PM 68 PART 1 Introduction TA BLE 2.1 Primary 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 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 Type of Intermediary Depository institutions (banks) Contractual savings institutions Investment intermediaries mortgage loans for residential housing. Over time, these restrictions have been 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 5,000, 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 M02_MISH9547_10_GE_C02.indd 68 30/06/23 2:49 PM Chapter 2 Overview of the Financial System 69 TABLE 2.2 Principal Financial Intermediaries and Value of Their Assets Value of Assets ($ billions, end of year) Type of Intermediary 2000 2010 2020 2021 7,687 15,580 21,644 23,587 441 912 1,823 2,041 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 3,136 5,176 9,420 9,863 862 1,242 2,879 3,100 Pension funds (private) 4,355 4,527 12,035 13,169 State and local government retirement funds 2,293 2,661 9,513 9,818 1,140 1,439 1,607 1,671 Investment intermediaries Finance companies Mutual funds 4,435 7,935 19,563 22,209 Money market mutual funds 1,812 2,755 4,766 5,206 Source: Federal Reserve Flow of Funds Accounts: https://www.federalreserve.gov/releases/z1/, Tables L110, L114, L115, L116, L118, L120, L121, L122, L127. to pay out in benefits in the coming years, they do not have to worry as much as 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 around $10 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 M02_MISH9547_10_GE_C02.indd 69 30/06/23 2:49 PM 70 PART 1 Introduction from employers and from employees, who either have a contribution automatically 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, hedge 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. oney Market Mutual Funds These financial institutions have the characteristics M 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 2021, their assets had climbed to over $5 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 M02_MISH9547_10_GE_C02.indd 70 30/06/23 2:49 PM Chapter 2 Overview of the Financial System 71 securities by purchasing them from the corporation at a predetermined price and 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 M02_MISH9547_10_GE_C02.indd 71 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 Federally chartered of the Currency 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 Federally chartered Administration (NCUA) 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 30/06/23 2:49 PM 72 PART 1 Introduction 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. M02_MISH9547_10_GE_C02.indd 72 30/06/23 2:49 PM Chapter 2 Overview of the Financial System 73 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 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 M02_MISH9547_10_GE_C02.indd 73 30/06/23 2:49 PM 74 PART 1 Introduction 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 M02_MISH9547_10_GE_C02.indd 74 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. 30/06/23 2:49 PM Chapter 2 Overview of the Financial System 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. 61 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 considering 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. M02_MISH9547_10_GE_C02.indd 75 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 about 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. If there were no asymmetry in the information that a borrower and a lender had, could there still be a moral hazard problem? 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 are the key functions 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? 30/06/23 2:49 PM 76 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 Levels 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? M02_MISH9547_10_GE_C02.indd 76 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? 30/06/23 2:49 PM CHAPTER 3 C H A P T E R PART 2 FUNDAMENTALS OF FINANCIAL MARKETS What Do Interest Rates Mean, and What Is Their Role in Valuation? PREVIEW Interest rates are among the most closely watched mean when they use the term interest rate. We variables in the economy. Their movements are discuss how the yield to maturity is measured on reported almost daily by the news media because they credit market instruments and how it is used to directly affect our everyday lives and have important value these instruments. We also see that a bond’s consequences for the health of the economy. They interest rate does not necessarily indicate how good affect personal decisions such as whether to consume an investment the bond is because what it earns (its or save, whether to buy a house, and whether to rate of return) does not necessarily equal its interest purchase bonds or put funds into a savings account. rate. Finally, we explore the distinction between real Interest rates also affect the economic decisions of interest rates, which are adjusted for changes in the businesses and households, such as whether to use price level, and nominal interest rates, which are not. 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 financial Although learning definitions is not always the most exciting of pursuits, it is important to read carefully and understand the concepts presented markets, we must understand exactly what the in this chapter. Not only are they continually phrase interest rates means. In this chapter, we used throughout the remainder of this text, but a see that a concept known as the yield to maturity firm grasp of these terms will give you a clearer is the most accurate measure of interest rates; understanding of the role that interest rates play in the yield to maturity is what financial economists your life as well as in the general economy. 77 M03_MISH9547_10_GE_C03.indd 77 26/06/23 7:32 AM 78 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 $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: i = $100 × (1 + 0.10) = $110 If you then lent out the $110, at the end of the second year you would have: $110 × (1 + 0.10) = $121 or, equivalently, $100 × (1 + 0.10) × (1 + 0.10) = $100 × (1 + 0.10) 2 = $121 Continuing with the loan again, at the end of the third year you would have: $121 × (1 + 0.10) = $100 × (1 + 0.10) 3 = $133 Generalizing, we can see that at the end of n years, your $100 would turn into: $100 × (1 + i) 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: M03_MISH9547_10_GE_C03.indd 78 Today 0 Year 1 Year 2 Year 3 Year n $100 $110 $121 $133 $100 3 (1 1 0.10)n 26/06/23 7:32 AM

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