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Financial Markets

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FOUNDATIONS OFFINANCIAL MARKETSAND INSTITUTIONSmmc I/AIEABQZZI I MODIGLIANI I JONES A\.I-I44.1 .9$8444URTHPrank I. FabozziYale School ofManagementFranco ModiglianiSloan School ofManagemenr,Massachusetts Institute of TechnologyFrank I. IonesCollege ofBusiness, San jose State UniversityPrentice Hallston* San Francisco s New York London n Toronto Sydney -yo Singapore Madrid Mexico City Munich ' Paris\ . Cape Town Hong Kong - MontrealFOEDITIONi __ffxiLibrary ofCongress Cataloging-in- Publication DataFabozzi, Frank ].Foundations of Hnancial markets and institutions/ Frank l- Faboui, Franco Modigliani,Frank I. Iones. -- 4th ed.p. cm.ISBN- 1 3: 978-0-1 3-61 3531-9ISBN- 1 O: 0-13-61 3531-5l. Finance. 2. Financial institutions. I. Modigliani, Franco. II. Iones, Frank Joseph. III. Title.HG 1 73.F29 2009332.1--dc22 2008050364Editor in Cliieti Donna BattistaAssistant Editor: Mary Kate MurrayManaging Editor: Jeff HolcombSenior Production Supervisor: Marilyn LloydMedia Project Manager: Holly Wallace BasticrSenior Manufacturing Buyer: Carol MelvillePermissions Supervisor: Charles MorrisProject Management: Andrea ShearerComposition, Illustrations, andAlterations: GGS Higher Education Resources,a Division of PreMedia Global, lmc.Text Design: Susan RaymondCover Designa: Elena SidorovaCover Image kffSpielman/Getty ImagesCredits and acknowledgments borrowed from other sources and reproduced, with permission, in this textbookappear on the appropriate page within the text.Copyright (c) 2010 Pearson Education, Inc. All rights reserved. No part of this publication may be reproduced,stored in a retrieval system, or transmittecl. in any form or by :mv means,electronic. n1ed1anical, photocopying,recording, or otherwise, without the prior written permission of the publisher. Printed in the United States ofAmerica. For information on obtaining permission for use of material in this work, please submit a writtenrequest to Pearson Education, lmc., Rights and Contracts Department, 501 Boylston Street,Suite 900, Boston, MA021 1 6, fax your request to 6 17-671-3447, or e-mail at http://wv/w.pearsoned.comllegal/permissions.htm.Prentice Hallis an imprint ofwww.pearsonhighered.com123455789 10-HAM-13 12 ll 1009ISBN-13: 978-0-13-61 3531-9ISBN-10' 0-l3~61353l-5This book is dedicated to Nobel laureate Franco Modigliani.On September 25, 2003, Professor Franco Modigliani passed away at his home in Cambridge,Massachusetts. He was 85 years old. He won the Nobel Prize in EconomicSciences in 1985 for his pioneering analyses of savings and financial marketsand capital structure theory.Professor Modigliani, who joined the MIT faculty in 1962, had degrees fromthe University of Rome and the New School for Social Research in New York City. He taughtand did research at several universities before joining the faculty at the Camegie Institute ofTechnology in 1952. He went to MIT 10 years later as a professor of economics and finance andin 1970, was named an Institute Professor, an appointment MIT reserves for scholars ofdistinction, He became professor emeritus in 1988.Modigliani received MITs Barnes R- Killian Faculty Achievement Award in 1985.The Modigliani Professorship of Financial Economics, an endowed diair,was established in 1995.MIT Institute Professor Paul Samuelson, a friend and fellow Nobelist, said,"Franco Modigliani could have been a multiple Nobel winner. When he died, he wasthe greatest living macroeconomist. He revised Keynesian economics .from its Model T,Neander that, Great Depression model to its modern-day form."Professor Samuelson noted that Wall Street was populated with numerous expertswho had studied with Professor Modigliani. Modiglianis students included Nobellaureate Robert Merton, the 1997 winner.He was a great teacher, intense andcolorful, Samuelson said.M IT was lucky to have him for 40 years; he wasa jewel in our crown, active to the endProfessor Modigliani was known for his work on corporate finance, capitalmarkets, macroeconomics, and econometrics. "Franco was a giant among economistsand played a decisive role in the intellectual development of corporate finance," saidDean Richard Schmalensee of the Sloan School.His legendary enthusiasm and intensitynever flagged. He inspired generations of students and colleagues with his passion forusing economics to benelit society. Everyone who knew him, will miss him.88 3~i\viPrefacePart] Introduction1 Introduction2 Finandal Institutions, Finandal Intermediaries, and AssetManagement FirmsPart II Depository Institutions, the Federal Reserve,345and Monetary PolicyDepository Institutions: Activities and CharacteristicsThe U.S. Federal Reserve and the Creation of MoneyMonetary PolicyPart III Nondepository Fmancial Intermediaries678-Insurance CompaniesInvestment Companies and Exchange-Traded FundsPension FundsPart IV Determinants of Asset Prices and Interest Rates9101112Progenies and Pricing of Financial AssetsThe Level and Structure of Interest RatesThe "Term Structure of Interest RatesRisk/Return and Asset Pricing ModelsPart V Organization and Structure of Markets1314Primary Markets and the Underwriting of SecuritiesSecondary MarketsPart VI Markets for Government Debt1516Treasury and Agency Securities MarketsMunidpal Securities MarketsPart VII Markets for Corporate Securities1718192021Markets for Common Stock: The Basic CharacteristicsMarkets for Common Stock: Structure and OrganizationMarkets for Corporate Senior Instruments: IMarkets for Corporate Senior Instruments: IIThe Markets for Bank ObligationsPart VIII Mortgage and Securitized Asset Markets2223The Residential Mortgage MarketResidential Mortgage~Backed Securities Marketvi1120393961779595121155170170191217241269269282294294320334334364399414437447447464-\. ~H." ". Q.. ..4.. A .~.- ...." :" _:. _r.BriefTab1e of Contents I vii24 Market for Commercial Mortgage Loans and CommercialMortgage-Backed Securities25 Asset-Backed Securities MarketsPart IX Markets for Derivative Securities26 Financial Futures Markets27 Options Markets28 Pricing of Futures and Options Contracts29 The Applications of Futures and Options Contracts30 OTC Interest Rate Derivatives: Forward Rate Agreements,Swaps, Caps, and Floors31 Market for Credit Risk Transfer Vehicles: Credit Derivatives andCollateralizes Debt Obligations32 The Market for Foreign Exchange and Risk Control InstrumentsIndex495505522522541565589600629652673-1...-ll-l.,: 84840Part I Introduction1 IntroductionLearning ObjectivesFinancial AssetsFinancial MarketsGlobalization of Financial MarketsDerivative MarketsThe Role ofthe Government in Financial MarketsFinancial InnovationSummaryKey TermsQuestions2 Financiad Institutions, Financial Intermediaries, and AssetManagement FirmsLearning ObjectivesFinancial InstitutionsRole ofliinancial IntermediariesOverview ofAsset/Liability ManagementforFinancial InstitutionsConcerns ofRegulatorsAsset Management FirmsSummaryKey TermsQuestionsPart II Depository Institutions, the Federal Reserve,and Monetary Policy3 Depository Institutions: Activities and CharacteristicsLearning ObjectivesAsset/Liability Problem ofDepository InstitutionsCommercial BanksSavings and Loan AssociationsSavings BanksCredit UnionsSummaryKev TermsQuestions11125791215171818202021222427293536373939394042515556575859ixPrefacexiiix | Contents4 The U.S. Federal Reserve and the Creation of MoneyLearning ObjectivesCentral Banks and Their PurposeThe Central Bank of the United States: The Federal Reserve SystemInstruments ofMonetary Policy: How the Fed Influences the Supph/ ofMoneyDifferent Kinds ofMoneyMoney and Monetary AggregatesThe Money Multiplier: The Expansion ofthe Money SupplyThe Impact oflnterest Rafes on the Money SupplyThe Money Supply Process in an Open EconomySummaryKey TermsQuestions5 Monetary PolicyLearning ObjectivesGoals ofMonefary PolicyTrade-Offs and Conflicts among PoliciesGoals and Types ofTargefsA Review ofRecenf Federal Reserve PolicySummaryKey TermsQuestionsPart III Nondepository Financial Intermediaries6 Insurance CompaniesLearning ObjectivesZi)/pes oflnsuranceInsurance Companies versus Types ofProductsFundamen tals ofthe Insurance IndustryRegulation ofthe Insurance IndustryStructure oflnsurance CornprzniesForms oflnsurance Companies: Stock and MutualIndividual versus Group Insurance /Tj-'pcs of Le InsuranceGeneral Account and Separate Account ProductsParticipa ting PolicesInsurance Company Investment StrategiesCnanffes in the Insurance IndustryEvolution of Insurance, Investment; and Retirement ProductsSummaryKey TermsQuestions6161626465686870727374757577777882828593939395959596101103104105106109109112113113114116119119120Contents7 Investment Companies and Exchange-Traded FundsLearning ObjectivesTypes oflnvestment CompaniesFund Sales Charges and Annual Operating ExpensesEconomic Motivation for FundsTypes ofFunds by Investment ObjectiveThe Concept ova Family ofFundsInvestment Vehicles for Mutual FundsMutual Fund CostsTaxation o_fMu qual FundsRegulation ofFundsStructure of a FundRecent Changes in the Mutual Fund IndustryAlternatives to Mutual FundsExchange- Traded FundsSummaryKey TermsQuestions8 Pension FundsLearning ObjectivesIntroduction to Pension PlansTypes ofPension PlansInvestmentsRegulationManagers ofPension FundsPension Protection Act of2006SummaryKey TermsQuestionsxi12112112212513113113513613613713713914114-41451521531531551551561571601621631671681681689 Properties and Pricing of Financial AssetsLearning ObjectivesProperties ofFinanc~ia1 AssetsPrinciples ofPricing ofFinancial AssetsPrice Vofntilify ofFinanciu1 AssetsSummaryKey TermsQuestions10 The Level and Structure of Interest RatesLearning ObjectivesThe Theory of Interest Rates17017017/176180187188189191191192Part IV Determinants of Asset Prices and Interest Rates170xii 5 ContentsThe Determinants of the Structure oflnferest RatesSummaryKey TermsQuestionsll The Term Structure of Interest RatesLearning ObjectivesThe Yield Curve and the Term StructureForward RatesHistorical Shapes Observedfor the Treasury Yield CurveDeterminants ofthe Shape ofthe Term StructureThe Main Influences on the Shape ofthe Yield CurveSummaryKey TermsQuestions12 Risk/Return and Asset Pricing ModelsLearning ObjectivesPortfolio TheoryThe Capital Asset Pricing ModelThe Multifactor Capital Asset Pricing ModelArbitrage Pricing Theory ModelAttacks on the TheorySummaryKey TermsQuestions2012 1221 321 421 721 721 822422923023623723923924124124225225725826026526726713 Primary Markets and the Underwriting of SecuritiesLearning ObjectivesThe Traditional Processfor Issuing New SecuritiesRegulation ofthe Primary Market\/hriations in :he Underwriting ProcessPrimfe Placement ofSecuritiesSummaryKey TermsQuestions14 Secondary MarketsLearning ObjectivesFunction ofSecondary ] marketsTrading LocationsMarket StructuresPerkct Ma rketsRole ofBrokers and Dealers in Real MarketsMarket Ejqciency269269270272273278280280280282282283283284284285288Part V Organization and Structure of Markets269Electronic TradingSummaryKey TermsQuestionsContentsxiii28929129229215 Treasury and Agency Securities MarketsLearning ObjectivesMarketfor Treasury SecuritiesMarketfor Federal Agency SecuritiesNon-U.S. Government Bond MarketsSummaryKey TennsQuestions16 Municipal Securities MarketsLearning ObjectivesTypes and Features ofMunicipal SecuritiesMunicipal Bond RatingsTax Risks Assonated with Investing in Municipal SecuritiesThe Primary MarketThe Secondary MarketThe Taxable Municipal Bond MarketYields on Municipal BondsRegulation ofthe Minzlcipal Securities MarketSummaryKey TermsQuestions29429429531 O31331631731832032032132432632732732832832933133233217 Markets for Common Stock: The Basic CharacteristicsLearning ObjectivesCommon Stock CharacteristicsTrading MechanicTransaction CostsTradingArrangemenfsfor Retail and Institutional InvestorsBasic Functioning ofStock MarketsStock Market IndicatorsPricing Eciency of the Stock A/IarkefSummaryKey TermsQuestions18 Markets for Common Stock: Structure and OrganizationLearning ObjectivesExchange Wf rket Sfructu res33433433533634134334735235736036 I362364364366Part VI Markets for Government Debt294Part VII Markets for Corporate Securities334xiv ContentsChanges in Exchange Ownership and Trading StructuresThe U.S. Stock Markets: Exchanges and Over-the-Counter MarketsOff-Exchange Markets/Alternative Electronic MarketsEvolving Stock Market PracticesSummaryKey TermsQuestions19 Markets for Corporate Senior Instruments: ILearning ObjectivesCredit RiskCommercial PaperMedium-Term NotesBank LoansSummaryKey TermsQuestions20 Markets for Corporate Senior Instruments: IILeu ruing ObjectivesCorporate BondsPreferred StockBankruptcy and Creditor RightsSummaryKey TermsQuestions21 The Markets for Bank ObligationsLearning ObjectivesTypes ofBanks Operating in the United StatesLarge-Denomination Negotiable CertU?cafes ofDepositFederal FundsBankers AcceptancesSummaryKey TermsQuestions37037238439039539739739939940040140540841141241241441441542943243343443543743743843844144244544544622 The Residential Mortgage Market.Learning ObjectivesOrigination ofResidential Mortgage LoansTypes ofResiden till Mortgage Loa nsConforming LoansIn vesfmen t RisksSummaryKey TermsQuestions `447447448452459460461462463Part VIII Mortgage and Securitized Asset Markets447Contents23 Residential Mortgage-Backed Securities MarketLearning ObjectivesSectors ofthe Residential Mortgage-Backed Securities MarketAgency Mortgage Pass- Through SecuritiesAgency Collateralizes Mortgage ObligationsAgency Stripped Mortgage-Backed SecuritiesNonagenqv on Mortgage-Backed SecuritySummaryKey TermsQuestions24 Market for Commercial Mortgage Loans and CommerdalMortgage~Backed SecuritiesLearning ObjectivesCommercial Mortgage LoansCommercial Mortgage-Backed SecuritiesSummaryKey TermsQuestions25 Asset-Backed Securities MarketsLearning ObjectivesCreation oran Asset-Backed SecurityCollateral Type and Securitization StructureReview ofMajor Non -Mortgage-Relf ted Types ofABSCredit Risks Associa ted with Investing in Asset- Backed SecuritiesSecuritization and the Impact on Financial MarketsSummaryKey TermsQuestionsxv4644644654654774864884934934944954954964985035045045055055065 1151251551851952052026 Financial Futures MarketsLearning ObjectivesFutures ContractsFu tures versus Forward Con tractsThe Role ofFutures in Financial MarketsU.S. Financial Futures MarketsThe General Accounting Ojice Study on Financial DerivativesSummaryKey TermsQuestions27 Options MarketsLearning ObjectivesOptions ContractsDifferences between Options and Futures Contracts522522523528529530537538539540541541542543Part IX Markets for Derivative Securities522xvi ContentsRisk and Return Characteristics ofOptionsEconomic Role ofthe Options MarketsU.S. Options MarketsFutures OptionsSummaryKey TermsQuestions28 Pricing of Futures and Options ContractsLearning ObjectivesPricing ofPutures ContractsPricing afOptio nsSummaryKey TermsQuestions29 The Applications of Futures and Options ContractsLearning ObjectivesApplications ofFutures ContractsApplications of Options ContractsSummaryKey TermsQuestions30 OTC Interest Rate Derivatives: Forward Rate Agreements,Swaps, Caps, and FloorsLearning ObjectivesForward Rate AgreementsInterest Rate SwapsInterest Rate Caps and FloorsSummaryKey TermsQuestions31 Market for Credit Risk Transfer Vehicles: Credit Derivatives andCollateralized Debt ObligationsLearning ObjectivesCredit DerivativesCredit Default SwapsCollateralizes Debt ObligationsStructured Finance Operating CompaniesCredit-Linked NotesConcerns with New Credit Risk Transjizr VehiclesSummaryKey TermsQuestions544552554559561562563565565566574585586586589589590595597597597600600601603622625626626629629631634639644645645648649650Contents32 The Market for Foreign Exchange and Risk Control InstrumentsLearning ObjectivesThe EuroForeign-Exchange Ra tesSpot MarketInstruments for Hedging Foreign-Exchange RiskSummaryKey TermsQuestionsIndexxvii652652653654657659669669670673Q11 ._ ."~.:fIn the preface to the first edition of this book published in 1994, we wrote that the prior 30 years had been atime of profound, indeed revolutionary, change in the financial markets and institutions of the world. Thehallmarks of that change were innovation, globalization, and deregulation. Since 1994, those forces have actu-ally gathered more strength, and the financial landscape continues to undergo large and visible changes aroundthe globe. The discipline that we know as finance has attracted the talents and energies of people from aroundthe world.Our purpose in writing this book is to instruct students about this fascinating revolution. We describe the widearray of financial securities that are now available for investing, funding operations, and controlling various typesof tinancia1 risk. We help the students to see each kind of security as a response to the needs ofborrowers, lenders,and investors, who manage assets and liabilities in a world of constantly changing interest rates, asset prices, regu-latory constraints, and international competition and opportunities. Our book devotes a considerable amount ofspace to explaining how the worlds key financial institutions manage their assets and liabilities and how innovativeinstruments support that management. We think Our focus on the actual practices of financial institutions is par-ticularly beneficial to students who will, as noted above, inevitably have to respond to changes in those institutionsand their environment.This is the fourth edition of Foundations ofFinancia1 Markets and Institutions. The third edition was publishedin 2002 and in the preface to that edition we wroteit is a safe bet that change will mark the discipline of financeover the foreseeable future and will produce new lands of institutions, markets, and securities.The financial worldhas changed incredibly since 2002, as this fourth edi.tion demonstrates. This continuing change in the U.S. financialsystem, to its institutions, its markets, and its products is a major reason for the considerable time which has passedbetween the publication of the third edition in 2002 and this edition published in early 2009. We originallyintended to provide the fourth edition in 2007, but in trying to mice it up to date we kept delaying this edition.If we were writing a new edidon of a book on Aristot]es Metaphysics (approximately 350 BC) or ThucydidesThe History of the Peloponnesian War (351 BC), or even a textbook on business statistics, our perspective on thesetopics might change, but the subbed matter would be static. On the other hand, writing on the U.S. financial systemin the early twenty-first century is less like trying to hit a moving target when you are standing still and more liketrying to hit a moving target while riding on a high-speed train.Every month, every week, and even every day as we tried to complete this book brought a change in the U.S.financial structure which had to be incorporated into this book. But the third edition was becoming obsolete and anew edition had to be provided, and as this edition goes to press, the U.S. financial stmcture continues to change. Butwe can make several observations. First, the principles in this edition are current. The prindples have evolved butcertainly have not been part of a revolution. Second, the applications of the theory are current. These applicationsare embodied in the products, institutions, and markets. Third, several new products are included in this edition.U.S. financial institutions and markets have continued to evolve, and in some areas these changes may be trans-formative. These changes are current at the time of the prod action of this edition. But we were not able to stopprogress and change at the time of the preparation of this edition. Changes have continued to occur. Thus,inevitably this edition begins to become incomplete at the time it is provided.Overall, the fourth edition of Foundations ofFinanciaI Markets and Institutions is complete, thorough, and hassubstantial treatment of the U.S. financial products, institutions, and markets as of the fall of 2008. This willxixxx y Prefaceprovide students with a solid foundation for understanding the continually evolving U.S. financial system and willprovide them with the sense of institutional structure and the analytical tools that they will need to understand theinnovations that will surely occur throughout their careers.Frank Fabozzi is grateful to his wife Donna and children (Francesco, Patricia, and Karly) for creating a minimalchaotic environment that allowed him to complete this project. Prank Iones is grateful to his wife Sally, whose lim-itless support was indispensable.Frank I. FabozziFrank I- IonesNEWTOTHIS EDITIONNew ChaptersChapter 2 Financial Institutions, Financid Intermediaries, and Asset Management Firms Includes cov-erage of the concerns of regulators.Chapter 24 Market for Commercial Mortgage Loans and Commerdal Mortgage-Backed SecuritiesChapter 31 Market for Credit Risk Transfer Vehicles: Credit Derivatives and Collateralizes DebtObligationsSignificantly Revised ChaptersChapter 1 Introduction Includes a discussion of market regulation (including the U.S. Treasury/sBlueprint for Regulatory Reform) and the causes of financial innovation.Chapter 12 Risk/Return and Asset Pricing Models Covers attacks on the traditional theory of portfolioselection, including a discussion of asset return distributions (fat tails), dternative risk measures, andbehavioral finance theory.Chapters 17 Markets for Common Stock: The Basic Characteristics and 18 Markets for CommonStock: Structure and Organization Now includes topics such as electronic trading, international anddomestic mergers for the NYSE and Nasdaq, algorithmic trading, and interndization.Chapter 19 Markets for Corporate Senior Instruments: I Now has coverage of the secondary marketfor bank loans.Chapter 22 The Residential Mortgage Market Revision of the residential mortgage market discussionto include subprime loans.Online AppendicesAdditional content available on the companion website at Www.pearsonhighered.com/fabozzi/.. Chapter 4 Appendix Central Banks of CountriesChapter 9 Appendix Review of Present ValueChapter 18 AppendixA The Current NYSE Stock MarketPreface | xxiChapter 18 Appendix B Major Non~U.S. Stock ExchangesChapter 29 Appendix General Principles of Hedging with FuturesAlso listed on the website is a list of the central banks of countries throughout the world.INSTRUCTOR SUPPLEMENTSThe following supplements are available to adopting instructors:instructors Resource Center Register.Redeem.Loginwww.pearsonhighered.com/irc is where instructors can access a variety of print, media, and presentation reso urgesthat are available with this text in downloadable, digital format.Itgets betten Once you register, you will not have additional forms to fill out, or multiple usernames and passwordsto remember to access new titles and/or editions. As a registered faculty member, you can log in directly to down-load resource files, and receive immediate access and instructions for installing Course Management content toyour campus server.Need help? Our dedicated Technical Support team is ready to assist instructors with questions about the mediasupplements that accompany this text. Visit: http://247pearsoned.custhelp.com/ for answers to frequently askedquestions and toll-free user support phone numbers. The following suppler ends are available to adopting instruc-tors. Detailed descriptions of the following supplements are provided on the Instructors Resource Center:Electronic Instructors Manual with SolutionsPrepared by Professor Robert Rhee of The University of Maryland School of Law. The Instructs rs Manual containschapter summ aries and suggested answers to all end-of-chapter questions.PowerPoint PresentationPrepared by Professor Roben Rhee of The University of Maryland Sdiool of Law. The PowerPoint slides providethe instructor with individud lecture outlines to accompany the text. The slides include all of the figures and tablesfrom the text. These lecture notes can be used as is or professors can easily modify them to reflect specific presen-tation needs.Test BankPrepared by Dr. Rob Hull of Washburn University School of Business has been written specifically for this edition.Each chapter consists of multiple-choice, true/false, and short-answer questions with learning objedive referencesand difficulty level provided for each question.E sFrank I. Fabozzi is Professor in the Practice of Finance and Becton Fellow at the Yale School of Management. Priorto joining the Yale faculty, he was a Visiting Professor of Finance in the Sloan School at MIT. Professor Fabozzi is aFellow of the International Center for Finance at Yale University and on the Advisory Cou nail for the Departmentof Operations Research and Financial Engineering at Princeton University. He is an affiliated professor at theInstitute of Statistics, Econometrics and Mathematical Finance at the University of Karlsruhe (Germany). He is theeditor of the journal of Portfolio Management, an associate editor of journal ofFixed Income, Journal ofStructuredFinance, and Journal ofAs5ef Management, and an advisory board member of The Review ofFutures Markets. Heearned a doctorate in economics from the City University of New York in 1972. In 2002, Professor Fabozzi wasinducted into the Fixed Income Analysts Societys I-Icll of Fame and in 2007, was the recipient of the C. StewartSheppard Award given by the CFA Institute. He earned the designation of Chartered Financial Analyst andCertined Public Accountant. He has authored and edited numerous books.Franco Modigliani (1918~2003) was the Institute Professor and Professor of Finance and Economics at MIT Hewas an Honorary President of the International Economic Ass.ociation and a former President of the AmericanEconomic Association, the American Finance Association, and the Econometric Society. He was a member of severalacademies, including the National Academy ofScience. The late Professor Modigliani authored numerous books andarticles in economics and fmance. In October 1985, he was awarded the Alfred Nobel Memorial Prize in EconomicSciences. Professor Modigliani received a Doctor of Jurisprudence in 1939 from the University of Rome and aDoctor of Social Science in 1944 from the New School for Social Research, as well as several honorary degrees.Frank jones is a Professor of Finance and Accounting at San lose State University College of Business. ProfessorIones has been on the Graduate Faculty of Economies at the University of Notre Dame, an Adjunct Professor ofFinance at New York University, and a lecturer at the Yde School of Management. Prior to returning to academia,he was the Executive Vice President & Chief Investment Officer of The Guardian Life Insurance Company,President of The Park Avenue Portfolio, the Chairman of the International Securities Exchange, Director of GlobalFixed Income Research and Economics at Merrill Lynch 8< Company, and Senior Wee President at the New YorkStock Exchange. He is on the editorial boards of the Ioumal 0fPortfolio Management and the Financial-Anab/stsJournal. He received a doctorate from Stanford University and a Master of Science in nuclear engineering fromCornell University. He is coauthor of several books in finance.xxiii .~ ~-:~*\sn gron \4 \ 4 9-~1 l 1 )4 I| 44 4Hv T_ J0-I \. 349 \49_ .v\..':..4\nw*4I vig.no; \ 'P9\adilcciimsst._\'l~14' u"5"5::'*~'4 o H* fillr ..* 1I*sC. ";;- Ya 59.5,Ai.k I..A 2+ .n-I _ 3 ~_; '*_ 9_ un ,vo o ..;~_ -. .qi F uw.*t~$'?' 1: 1 , _ *e..vi.\.- .. .* {. .\ 1 2 4 s pl* ,'\.:,. ' 1:3, ,., 4 .89-4 . ,.*_ .".4* *ef Pr'8aT--1.si-' 3. .anea-9 . 4 1i J .-=f3f .-*=. - 1 4=.*4*U .. 4 5'~x. I 9f,*"E **|* "*\l\ I .1_ *Z 3 ._ -"v* \1.\9* -"*" H1 ...J *=.a*~ f-*` T**'P'?3 9.-34~~f"'3?""*ir_~1`-' if -;i1,.f9:3_~ 3 " * * - -*\"1 " _f~*~~ f* fri- -*La _Ti*;.f 5- 44 4 J ful.;l; ~=.:=f_.],'._,.-l. . \ .ll u ""e * .\ * J nh ==* ..- 4' tl 5. .Z .- .4>="'J . ~`.JM f""*=~?._?4==4~'2\8Par t] Introduction,l""7u'*:f*1"4.. , ,__ +-4,U.\../_,*,1~41 -41..~> sfby non-U.S. corporations in the United States must comply with the regulations set forth inU.S. securities law. A non-Iapanese corporation that seeks to offer securities in japan mustcomply with Japanese securities law and regulations imposed by the Japanese Ministry ofFinance. Nicknames have developed to describe the various foreign markets. For example,the foreign market in the United States is called the Yankee marker. The foreign market injapan is nicknamed the Samurai market, in the United Kingdom the Bulldog market, in theNetherlands the Rembrandt market, and in Spain the Matador market.The external market, also called the international market, allows trading of securitieswith two distinguishing features: (1) at issuance securities are offered simultaneously toinvestors in a number of countries, and (2) they are issued outside the jurisdiction of anysingle country The external market is commonly referred to as the offshore market, or,more popularly, the Euromarket.Motivation for Using Foreign Markets and EuromarketsThere are several reasons why a corporation may seek to raise funds outside its domesticmarket. First, in some countries, large corporations seeking to raise a substantial amount offunds may have no choice but to obtain financing in either the foreign market sector ofanother country or the Eurornarket. This is because the fund-seeking corporations domes-tic market is not fully developed and cannot satisfy its demand for funds on globally com-petitive terms. Governments of developing countries have used these markets in seeldngfunds for government-owned corporations that they are privatizing.The second reason is that there may be opportunities for obtaining a lower cost offunding than is available in the domestic market, although with the integration of capitalmarkets throughout die wo.r]d, such opportunities have diminished. Nevertheless, there arestill some imperfections in capital markets throughout the world that may permit areduced cost of funds. The causes of these imperfections are discussed throughout thebook. A Enal reason for using foreign or Euromarkets is a desire by issuers to diversify theirsource of funding so as to reduce reliance on domestic investors-1. The three major factors that have integrated financial markets Lhroughout the world.2. What is meant by the institutionalization offinancial markets.3. Vtfhat is meant bv an internal market (or national market), domestic market,foreign market, and external market (or international market, offshore market, orEuromarket).4. The motivations for U.S. corporations to raise money outside the United States.i|I DERIVATIVE MARKETSSo far we have focused on the cash market for financial assets. With some contracts, thecontract holder has either the obligation or the choice to buy or sell a financial asset atsome future time. The price of any such contract derives its value from the value of theI The classification we use is by no means universally accepted. Some market observers and compilers of statisti-cal data on market activity refer to the cxternalmarkct as consisting of the foreign market and the Euromarket.Chapter 1 Introduction9Key Points That Ycu Should Understand Before ProceedingIunderlying financial asset, Enancial index, or interest rate. Consequently, these contractsare called derivative instruments.Types of Derivative InstrumentsThe two basic types of derivative instruments are futures/forward contracts and options con-tracts. A futures or forward contract is an agreement whereby two parties agree to transactwith respect to some financial asset at a predetermined price at a specified future date. Oneparty agrees to buy the financial asset; the other agrees to sell the financial asset. Both par-ties are obligated to perform, and neither party charges a fee. The distinction between afutures and forward contract is explained in Chapter 26.An options contract gives the owner of the contract the right, but not the obligation, tobuy (or sell) a financial asset at. a specified price from (or to) another party. The buyer ofthe c.ontract must pay the seller a fee, which is called the option price. When the optiongrants the owner of the option the right to buy a Enancial asset from the other party theoption is called a call option. If instead, the option grants the owner of the option therightto sell a Enancial asset to the other party, the option is called a put option. Options are morefully explained in Chapter 27.Derivative instruments are not limited to financial assets. There are derivative instm-ments involving commodities and precious metals. Our focus in this book, however, is onderivative instruments where the underlying asset is a financial asset, or some financialbenchmark such as a stock index or an interest rate, a credit spread, or foreign exchange.Moreover, there are other types of derivative instruments that are basicallypackages ofeither forward contracts or option contracts. These include swaps, caps, and floors, all ofwhich are discussed in Chapter 30.The Role of Derivative InstrumentsDerivative contracts provide issuers and investors an inexpensive way of controlling somemajor risks. While we will describe these risks in later dmpters of this book, here are threeexam plus that clearly illustrate the need for derivative contracts:1. Suppose that Verizon Communications plans to obtain a bank loan for $100 milliontwo months from now. The key risk here is that two months from now the interest ratewill be higher than it is today. If the interest rate is only one percentage point higher,Verizon Communications would have to pay $1 million more in annual interest. Clearly,then, issuers and borrowers want a way to proved against a rise in interest rates-2. IBM pension fund owns a portfolio consisting of the common stock of a large num-ber of companies. (We describe the role of pension funds in Chapter 8, but for nowthe only thing that is im portant to understand is that the pension fund must makeperiodic payments to the beneficiaries of the plan.) Suppose the pension fund knowsthat twomonths from now it must sell stock in its portfolio to pay beneficiaries$20 million. The risk that IBM pension fund faces is that two months from now whenthe stocks are sold, the price of most or all stocks may be lower than they are today. Ifstock prices do decline, the pension fund will have to sell off more shares to realize$20 million. Thus. investors, such as the IBM pension fund, face the risk of decliningstock prices and may want to protect against this risk.3. Su prose Sears, Roebuck plans to issue a bond in Switzerland and the periodic pay-ments that the company must make to the bondholders are denominated in the Swisscurrency; the franc. The amount of U.S. dollars that Sears must pay to receive the10Partl IntroductionChapterl Introduction i 11amount of Swiss francs it has contracted to pay will depend on the exchange rate atthe time the payment must be made. For example, suppose that at the time Searsplans to issue the bonds, the exchange rate is such that 1 U.S. dollar is equal to1.5 Swiss francs. So, for each 7.5 million Swiss francs that Sears must pay to thebondholders, it must pay U.S. $5 million. If at any time that a payment must be madein Swiss francs, the value of the U.S. dollar declines relative to the Swiss franc, Searswill have to payrnore U.S. dollars to satisfy its contractual obligation. For example, if1 U.S. dollar at the time of a payment changes to 1.25 Swiss francs, Sears would haveto pay $6 million to make a payment of7.5 million Swiss francs. This is U.S. $1 mil-lion more than when it issued the bonds. Issuers and borrowers who raise funds in acurrency that is not their local currency face this risk.The derivative instruments that we describe in Part IX of this book can be used by thetwo borrowers (Verizon Communications and Sears, Roebuck) and the one investor (IBMpension fund) in these examples to eliminate or to reduce the lands of risks that they face.As we will see in la ter chapters, derivative markets may have at least three advantagesover the corresponding cash (spot) market for the same financial asset. First, depending onthe derivative instrument, it may cost less to execute a transaction in the derivatives marketin order to adjust the risk exposure of an investor's portfolio to new economic informationthan it would cost to make that adjustment in the cash market. Second, transactions typi-cally can be accomplished faster in the derivatives market. Third, some derivative marketscan absorb a greater dollar transaction without an adverse effect on the price of the deriva-tive instrument; that is, the derivative market may be more liquid than the cash market.The key point here is that derivative instruments play a critical role in global financialmarkets. A May 1994 report published by the U.S. General Accounting Office (GAO) titledFinancial Derivatives: Actions Needed to Protect the Financial System recognizes the impor-tance of derivatives for market participants. Page 6 of the report states:Derivatives serve an important function of the global financial marketplace, prO~riding end-users with opportunities to better manage financial risks associatedwith their business transactions. The rapid growth and increasing complexity ofderivatives reflect both the increased demand from end-users for better ways tomanage their financial risks and the innovative capacity of the financial servicesindustry to respond to market demands.Unfortunately, derivative markets are too often viewed by the general public-andsom etimes regulators and legislative bodies-as vehicles for pure speculation (that is, legal-ized gambling). Without derivative instruments and the markets in which they trade, thefinancial systems throughout the world would not be as integrated as they are today..i3. The potential advantages of using derivative instruments rather than cash marketinstruments._iKey PointsThatYou Should Understand Before Proceeding1. The two basic types of derivative instruments: futures/forward contracts andoptions.I2. The principal economic role of derivative instruments.il12 | Parti IntroductionITHE ROLE OF THE GOVERNMENT IN FINANCIAL MARKETSBecause of the prominent role played by financial markets in economies, governments havelong deemed it necessary to regulate certain aspects of these markets. In their regulatorycapacities, governments have greatly influenced the development and evolution of financialmarkets and institutions. As stated in a March 31, 2008, speech by Henry M. Paulson, Ir.,Secretary of the U.S. Department of the TreasuryzzA strong financial system is vitally impor tant-not for Wall Street, not for bankers,but for worldng Americans. When our markets work, people throughout our econ-omy benefit-Americans seeking to buy a car or buy a home, families borrowing topay for college, innovators borrowing on the strength of a good idea for a newprodud or technology, and businesses financing investments that create new jobs.And when our Hnancial system is under stress, millions of working Americans bearthe consequences. Government has a responsibility to make sure our Enancial sys-tem is regulated effectively. And in this area, we can do a better job. In sum, the ulti-mate beneficiaries from improved financial regulation are Americas workers, fami-lies and businesses-both large and small.It is important to realize that governments, markets, and institutions tend to behaveinteractively and to affect one anothers actions in certain ways. Thus, it is not surprising tofind that a markets reactions to regulations often prompt a new response by the govern-ment, which can cause the institutions participating in a market to change their behaviorfurther, and so on. A sense of how the government can affect a market and its participantsis im portant to an understanding of the numerous markets and securities to be describedin the chapters to come. For that reason, we briefly describe the regulatory function here.Because of differences in culture and history, different countries regulate financial mar-kets and financial institutions in varying ways, emphasizing some forms of regulation morethan others. Here we will discuss the different types of regulation, the motivation for regu-lation, and the basic U.S. regulatory structure. At the time this book goes to press, there willhave been proposals for a drastic overhaul of the U.S. regulatory system.Justification for RegulationThe standard explanation or justification for governmental regulation of a market is thatthe market, left to itself, will not produce its particular goods or services in an efhcientmanner and at the lowest possible cost. Cf course, efhciency and low~cost production arehallmarks of a perfectly competitive market. Thus, a market unable to produce efficientlymust be one that is not competitive at the time, and that will not gain that status by itself inthe foreseeable future. Of course, it is also possible that governments may regulate marketsthat are viewed as competitive currently but unable to sustain competition, and thus low-cost production, over the long run. A version of this justification for regulation is that thegovernment controls a feature of the economy that the market mechanisms of competitionand pridng could not manage without help. A shorthand expression economists use to2 It is in this speech that Secretary Paulson introduced what is known as lhe"Blueprint for Regulatory Reformthat we will describe shortly.Chapter 1 Introdudion | 1 3describe the reasons for regulation is market failure. A market is said to fail init cannot, byitself, maintain all the requirements for a competitive situation.Governments in most developed economies have created elaborate systems of regula-tion for Hnancial markets, in part because the markets themselves are complex and in par tbecause Hnancial markets are so important to the general economies in which d1ey operate.The numerous rules and regulations are designed to serve several purposes, which fall intothe following categories:1. to prevent issuers of securities from defrauding investors by concealing relevantinformation2. to promote competition and fairness in the trading of financial securities3. to promote the stability of financial institutions4. to restrict the activities of foreign concerns in domestic markets and institutions5. to control the level of economic activityCorresponding to each of these categories issnimportant form of regulatijn. We discusseach form in turn.Disclosure regulation is the form of regulation that requires issuers of securities tomake public a large amount of financial information to actual and potential investors. Thestandard justification for disclosure rules is that the managers of the issuing firm have moreinformation about the financial health and future of the firm than investors who own orare considering the purchase of the firms securities. The cause of market failure here, ifindeed it occurs, is commonly described as asymmetric information, which meansinvestors and managers have uneven access to or uneven possession of information. This isreferred to as the agency problem, in the sense that the firms managers, who act as agentsfor investors, may act in their own interests to the disadvantage of the investors. The advo-cates of disclosure rules say that, in the absence of the rules, the investors comparativelylimited knowledge about the firm would allow the agents to engage in such practices.Financial activity regulation consists of rules about traders ofsecurities and trading onfinancial markets. A prime example of this form of regulation is the set of rules againsttrading by corporate insiders who are corporate officers and others in positions to knowmore about a arms prospects than the general investing public. Insider trading is anotherproblem posed by asymmetric information, which is of course inconsistent with a compet-itive market. A second example of this type of regulation would be rules regarding thestructure and operations of exchanges where securities are traded so as to minimize the riskof defrauding the general investing public.Regdation of financial institutions is the form of governmental monitoring thatrestricts these institutions acdvities in the vital areas of lending, borrowing, and funding.The justihcation for this form ofgovernment regulation is that these financial Erms have aspecial role to play in a modem economy. Financial institutions help households and. firmsto save; they also facilitate the complex payments among many elements of the economy;and in the case of commercial banks, they serve as conduits for the governments monetarypolicy Thus, it is often argued that the failure of these financial institutions would disturbthe economy in a severe way.Regulation of foreign participants is the form of governmental activity that limits theroles foreign firms can have in domestic markets and their ownership or control or finan-ciao institutions.Authorities use banking and monetary regulation to try to control changes in a coun-trys money supply, which is thought to control the level of economic activity.Later chapters will provide a detailed review of these types of governmental regulationof markets and financial institutions. We mention them here briefly in order to provide acomprehensive picture of the governments role in modern financial systems.Regulation in the United StatesThe regulatory structure in the United States is la rgely the result offinancial crises that haveoccurred at various times. Most regulations are the products of the stock market crash of1929 and the Great Depression in the 19305. Some of the regulations may make little eco-nomic sense in the current financial market, but they can be traced back to some abuse thatlegislators encountered, or thought they encountered, at one time- In fact, as noted bySecretary Paulson in his March 31, 2008, speech:Ourcurrent regulatory structure was notbuilt toaddress the modern financialsystem with its diversity of market participants, innovation, complexity of Enan-cial instruments, convergence of Hnancial intermediaries and trading platforms,global integration and interconnectedness among financial institutions, investors -and markets. Moreover, our financial services companies are becoming larger,more complex and more difficult to manage. Much of our current regulatorysystem was developed after the Great Depression and it has developed throughreaction-a pattern of creating regulators as a response to market innovations orto market stress.The current regulatory system in the United States is based on an array of industry- andmarket-focused regulators. Again, we will discuss the complex array of regulation when wedescribe the various financial institutions and financial markets. A proposal by the U.S.Department of the Treasury, popularly referred to as the "Blueprint for Regulatory Reformor simply Blueprint, would replace the prevailing complex array of regulators with a regu-latory system based on functions. More specifically, there would be three regulators;(1) a market stability regulator, (2) a prudential regulator, and (3) a business conduct regu-lator. The market stability regulator would take on the traditional role of the FederalReserve by giving it the responsibility and authority to ensure overall financial market sta-bility. The Federal Reserve, which we discuss in Chapter 4, would be responsible for moni-toring risks across the financial system. The prudential regulator would be charged withsafety and soundness of firms with federal guarantees that we will describe in this booksuch as federal depository insurance and housing guarantees. The business conduct regula-tor would regulate business conduct across all types of financial firms. This regulatorwould take on most of the roles that the Securities and Exchange Commission and theCommodity Futures Trading Com mission now have.This change in regulatory structure is the long-term recommendation of the Blueprint.This may not occur for 10 or 15 years, if at all. If history is our guide, major regulatorychanges do take that long to become legislation, Forexample, in Chapter 3, we will describethe major regulatory reform as of this writing: the Gramm-Leach-Bliley Act 1999.According to one source, portions of that legislation were first recommended by a specialcommission of the Reagan administration in the early to mid 19805.14Par tl IntroductionChapter] Introduction | 15 Key Paints ThitY6iil$lli9uld. undrsiand Befgr Procegdiflg '1. The standard explanation for governmental regulation of markets for goods andservices.2. What is being sought by regulation.3. The major forms of regulation.4. TheBlueprint for Regulatory Reform proposed by the U.S. Department of theTreasury. FINANCIAL INNOVATIONCategorizations of Financial InnovationSince the 1960s, there has been a surge in significant Enancial innovations. Observers offinancial markets have categorizes these innovations in different ways. Here are just threeways suggested to classify these innovations.The Economic Council of Canada classifies financial innovations into the followingthree broad categories?' market-broadening instruments, which increase the liquidity of markets and theavailability of funds by attracting new investors and offering new opportunities for bor-rowers risk-management instruments, which reallocate financial risks to those who are lessaverse to them, or who have offsetting exposure and thus are presumably better able toshoulder them arbirmging instruments and processes, which enable investors and borrowers to takeadvantage of differences in costs and returns between markets, and which reflect dif-ferences in the perception of risks, as well as in information, taxation, and regulationsAnother classification system of Hnancial innovations based on more specific functionshas been suggested by the Bank for In ternational Settlements: price-risk- tm nsferring innova-tions, credit-risk-transferring instruments, liquidity-generating innovations, credit-generatinginstruments, and equity-generating instruments'* Price-risk-transferring innovations arethose that provide market participants with more efficient means for dealing with price orexchange-rate risk. Reallocating the risk of default is the function of credit-risk-transferringinstruments. Liquidity-generating innovations do three things: ( 1) They increase the liquid-ity of the market, (2) they allow borrowers to draw upon new sources of funds, and (3) theyallow market participants to circumvent capital constraints imposed by regulations.Instruments to increase the amount of debt funds available to borrowers and to increase thecapital base of financial and nonfinancial institutions are the functions of credit-generatingand equity-generating innovations, respectively.Finally, Professor Stephen Ross suggests two classes of financial innovation: (1) new finan-cial products (financial assets and derivative instruments) better suited to the circumstances of3 Glohnlizarion and Canadas Finandnl Markets (Ottawa, Canada: Supply and Services Canada, i989), p. 32.4 Bank for International Settlements. Recent Innovations in International Banking (Basie: BIS, April 1986).16 i Par tl Introductionthe time (for example, to inflation) and to the markets in which they trade, and (2) strategiesthat primarily use these Hnancial products.5One of the purposes of this book is to explain these financial innovations. Por now, letslook at why Hnancial innovation takes place.Motivation for Financial InnovationThere are two extreme views offinancial innovation. There are some who believe that themajor impetus for innovation has been the endeavor to circumvent (or arbitrage) regula-tions and find loopholes in tax rules.7 At the other extreme, some hold that the essence ofinnovation is the introduction offinancial instruments that are more efficient for redistrib-uting risks among market participants.It would appear that many of the innovations that have passed the test of time and havenot disappeared have been innovations that provided more efficient mechanisms for redis-.tributing risk. Other innovations may just represent amore efficient way of doing things.Indeed, ifwe consider the ultimate causes offinancial innovation? the following emerge asthe most important:1. increased volatility of interest rates, inflation, equity prices, and exchange rates2. advances in computer andtelecommunicution technologies3. greater sophistication and educational training among professional marketpanicipants4. Enandal intermediary competition5. incentives to get around existing regulation and tax laws6. changing global patterns of financial wealthWith increased volatility comes the need for ver tain market participants to protectthemselves against unfavorably consequences. This means new or more efficient ways ofrisk sharing in the financial market are needed. Many of the financial products requirethe use of computers to create and monitor them. To implement trading strategies usingthese financial products also requires computers, as well as telecommunication andInternet networks. Without advances in computer and telecommunication technologies,some innovations would not have been possible. Although financial products and trad-ing strategies created by some market participants inav be too complex for other marketparticipants to use, the level ofmarket sophistication, par titularly in terms of mathemat-ical understanding, has risen, permitting the acceptance of some complex products andtrading strategies.As you read the chapters on the various sectors of the financial markets that wereview in this book, be sure you understand the Factors behind any innovations in thatmarket.5 5fPhen A. Russ,Institutional Markets. Financial Marketing, and Financial Innovation," journal afFinance.4 _13cChapter 2 Financial Institutions, Financial Intermediaries, and Asset Management Firms | 21n this chapter, we discuss financial institutions and a special and important type offinancial institution, a financial intermediary. Financial intermediaries include Com-mercial banks, savings and loan associations, investment companies, insurance companies,and pension funds. The most important contribution of financial intermediaries is a steadyand relatively inexpensive flow of funds from savers to final users or investors. Every mod-ern economy has Enancial intermediaries, which perform key Enancial functions for indi-viduals, households, corporations, small and new businesses, and governments. ln the lastpart of this chapter, we provide an overview of the organizations that manage funds forfinancial intermediaries as well as individual investors: asset management firms. FINANCIAL INSTITUTIONSBusiness entities include nonfinancial and financial entaprises. NonEnandal enterprises man-ufacture produds [e.g., cars, seew, computers) and/or provide nonfinancial services (e.g.,transportation, utilities, computer programming). Financial enterprises, more popularlyreferred to as finandal institutions, provide services related to one or more of the following:1. Transforming financial assets acquired through the market and constituting theminto a different, and more widely preferable, type of asset-which becomes their lia-bility This is the function performed by financial intermediaries, the most important. type of financed institution.2. exchanging of financial assets on behalf of customers3. exchanging of financial assets for their own accounts4. assisting in the creation of financial assets for their customers, and then selling thosefinancial assets to other market participants5. providing investment advice to other market participants6. managing the portfolios of other market participantsFinancial intermediaries include depository institutions (commercial banks, savingsand loan associations, savings banks, and credit unions), which acquire the bulk of theirfunds by offering their liabilities to the public mostly in the form of deposits; insurancecompanies (life and property and casualty companies); pension funds; and finance compa-nies. Deposit-accepting, or depository institutions, are discussed in Chapter 3. The otherfinancial intermediaries are covered in Chapters 6 through 8_The second and third services in the list above are the broker and dealer functions,which are discussed in Chapters 13 and 14. The fourth service is referred to as underwrit-ing. As we explain in Chapter 13, typically a financial institution that provides an under-writing service also provides a brokerage and/or dealer service.Some nonfinancial enterprises have subsidiaries that provide financial services. Forexample, many large manufaduring firms have subsidiaries that provide financing for theparent companys customer. These financial institutions are called captive _finance compa~nies. Examples include General Motors Acceptance Corporation (a subsidiary of GeneralMotors) and General Electric Credit Corporation (a subsidiary of General Electric).I 1. The services provided by financial institutions. 42. The special role played by a Enancial intermediary when it transforms assets acquired I Key Points That You Should Understand Before Proceedingi|from customers or the market into its own liabilities..II22 \ Part] IntroductionIRol.E OF FINANCIAL INTERMEDIARIESAs we have seen, financial intermediaries obtain funds by issuing financial claims againstthemselves to market participants, and then investing those funds. The investments madeby financial intermediaries-their assets-can be in loans and/or securities. These invest-ments are referred to as direct investments. Market par ticipants who hold the financialclaims issued by financial intermediaries are said to have made indirect investments.Two examples will illustrate this. Most readers of this book are familiar with what acommercial bank does. Commercial banks accept deposits and may use the proceeds tolend funds to consumers and businesses. The deposits represent the IOU of the commercialbank and a financial asset owned by the depositor. The loan represents an IOU of theborrowing entity and a financial asset of the commercial bank. The commercial bank hasmade a direct investment in the borrowing entity; the depositor effectively has made anindirect investment in that borrowing entityAs a secondexample, consider an investment company, a financial intermediary wefocus on in Chapter 7, which pools the funds of market participants and uses those fundsto buy a portfolio of securities such as stocks and bonds. Investment companies are morecommonly referred to asmutual funds." Investors providing funds to the investment com-pany receive an equity claim th at entitles the investor to a pro rata share of the outcome ofthe portfolio. The equity claim is issued by the investment company. The portfolio offinancial assets acquired by the investment company represents a direct investment that ithas made. By owning an equity claim against the investment company, those who invest inthe investment company have made an indirect investment.We have stressed that Hnancial intermediaries play the basic role of transforming finan-cial assets that are less desirable for a large part of the public into other financial assets-their own liabilities-which arc more widely preferred by the public. This transformationinvolves at least one of four economic functions: ( I) providing maturity intermediation,(2) reducing risk via diversihcation, (3) reducing the costs of contracting and informationprocessing, and (4) providing a payments mechanism. Each function is described below.Maturity intermediationIn our example of the commercial bank, two things should be noted. First, the maturity ofat least a portion of the deposits accepted is typically short term. For example, certain typesof deposit are payable upon demand. Others have a specific maturity date, but most are lessthan two years. Second, the maturity of the loans made by a commercial bank may be con-siderably longer than two years. In the absence of a commercial bank. the borrower wouldhave to borrow for a shorter term, or find an entity that is willing to invest for the length ofthe loan sought, and/or investors who make deposits in the bank would have to commitfunds for a longer length of time than they want. The Commercial bank, by issuing its ownfinancial daims, in essence transforms a longer-term asset into a shorter-term one by givingthe borrower a loan for the length of time sought and the investor/depositor a financialasset for the desired investment horizon. This function of a financial intermediary is calledmaturity intermediation.Maturity intermediation has two implications for financial markets. First, it providesinvestors with more choices concerning maturity for their investments; borrowers havemore choices for the length of their debt obligations. Second, because investors are naturallyChapter 2Financial Institutions, Financial Intermediaries, and Asset Management Firms | 23reluctant to commit funds for a long period of time, they will require that long-term bor-rowers pay a higher interest rate than on short-term borrowing. A financial intermediary iswilling to make longer-term loans, and at a lower cost to the borrower than an individualinvestor would, by counting on successive deposits providing the funds until maturity(although at some risk--see below). Thus, the second implication is that the cost oflonger-term bo growing is likely to be reduced.Reducing Risk via DiversificationConsider the example of the investor who places funds in an investment company. Supposethat the investment company invests the funds received in the stock of a large number ofcompanies. By doing so, the investment company has diversified and reduced its risk.Investors who have a small sum to invest would find it difficult to achieve the same degreeof diversification because they do not have sufficient funds to buy shares of a large numberof companies. Yet, by investing in the investment company for the same sum of money,investors can accomplish this diversification, thereby reducing risk.This economic function of Hnancial intermediaries-transforming more risky assetsinto less risky ones-is called diverszfcatioir. Although individual investors can do it ontheir own, they may not be able to do it as cost-effectively as a financial intermediary,depending on the amount of Funds they have to invest. Attaining cost-effective diversifica-tion in order to reduce risk by purchasing the financial assets of a financial intermediary isan important economic benefit for financial markets.Reducing the Costs of Contracting and Information ProcessingInvestors purchasing financial assets should take the time to develop skills necessary tounderstand how to evaluate an investment. Once those skills are developed, investorsshould. apply them to the analysis of specihc financial assets that are candidates for pur~chase (or subsequent sale). Investors who want to make a loan to a consumer or businesswill need to write the loan contract (or hire an attorney to do so).Although there are some people who enjoy devoting leisure time to this task, most pre-fer to use that time for just that-leisure. Most of us find that leisure time is in short sup-ply, so to sacrifice it, we have to be compensated. The form of compensation could be ahigher return that we obtain from an investment.In addition to the opportunity cost of the time to process the information about thefinancial asset and its issuer, there is the cost of acquiring that information. All these costsare called injfrrmation processing costs. The costs of writing loan contracts are referred to ascontracting costs. There is also another dimension to contra sting costs, the cost of enforc-ing the terms of the loan agreement.With this in mind, consider our two examples of financial intermediaries-the com-mercid bank and the investment company. Peoplewho work for these intermediariesinclude investment professionals who are trained to analyze financial assets and managethem. In the case of loan agreements, either standardizes contracts can he prepared, orlegal counsel can be part of the professional staff that writes contracts involving more com-plex transactions. The investment professionals can monitor compliance with the terms ofthe loan agreement and take any necessary action to protect the interests of the financialintermediary. The employment ofsuch professionals is cost-effective for financial interme-diaries because investing funds is their normal business.24 | Parti IntroductionIn other words, there are economies of scale in contracting and processing informationabout financial assets because of the amount of funds managed by financial intermediaries.The lower costs accrue to the benefit of the investor who purchases a financial claim of thefinancial intermediary and to the issuers of financial assets, who beneht from a lower bor-rowing cost.Providing a Payments MechanismAlthough the previous three economic functions may not have been immediately obvious,this last function should be. Most transactions made today are not done with cash. Instead,payments are made using checks, credit cards, debit cards, and electronic transfers of funds.These methods for maldng payments, called payment mechanisms, are provided by certainfinancial intermediates.At one time, noncash payments were restricted to checks written against non-interest-bearing accounts at commercial banks. Similar check writing privileges were provided laterby savings and loan associations and savings banks, and by certain types of investmentcompanies. Payment by credit card was also at one time the exclusive domain of commer-cial banks, but now other depository institutions offer this service. Debit cards are offeredby various financial intermediaries. A debit card differs from a credit card in that, in thelatter case, a bill is sent to the credit card holder periodically (usually once a month)requesting payment for transactions made in the past. In the case of a debit card, funds areimmediately withdrawn (that is, debited) from the purchasers account at the time thetransaction takes place.The ability to make payments without the use of cash is critical for the functioning of afinancial market. In short, depository institutions transform assets that cannot be used tomake payments into other assets that offer that property. Key Points ThatYou Should Understand Before Prdcedingl. The difference between a direct investment and an indirect investment.2. How a financial institution intermediates among investors and borrowers in the areaof maturity, reduces risk and offers diversification, reduces the costs of contractingI and information processing, and provides payment mechanisms.L_OVERVIEW OF ASSET/LIABILITY MANAGEMENTI FOR FINANCIAL 1NsTmmoNsIn later chapters, we discuss the major financial institutions. To understand the reasonsmanagers of financial institutions invest in particular types of financial assets and thetypes.of` investment strategies they employ, it is necessary to have a general understandingof the asset/liability problem faced. In this section,we provide an overview of asset/liabilitymanagement.The nature of the liabilities dictates the investment strategy a financial institution willpursue. For example, depository institutions seek to generate income by the spreadbetween the return that they earn on assets and the cost of their funds. That is, they buymon ey and sell money. They buy money by borrowing from depositors or other sources ofChapter 2Financial Institutions, Financial Intermediaries, and Asset Management Firms | 25Funds. They sell money when they lend it to businesses or individuals. ln essence, they arespread businesses. Their objective is to sell money for more than it costs to buy money.The cost of the funds and the return on the funds sold is expressed in terms of an interestrate per unit of time. Consequently, the objective of a depository institution is to earn apositive spread between the assets it invests in (what it has sold the money for) and the costsof its funds (what it has purchased the money for).Life insurance companies--and, to a certain extent, property and casualty insurancecompanies--are in the spread business. Pension funds are not in the spread business in thatthey do not raise funds themselves in the market. They seek to cover the cost of pensionobligations at a minimum cost that is borne by the sponsor of the pension plan, Innes amentcompanies face no explicit costs for the funds they acquire and must satisfy no specific lia-bility obligations; one exception is a particular type of investment company that agrees torepurchase shares at any time.Nature of LiabilitiesBy the liabilities of a financial institution, we mean the amount and timing of the cash out-lays that must be made to satisfy the contractual terms of the obligations issued. The liabil-ities of any financial institution can be categorizes according to four types as shown inTable 2-1. The categorization in the table assumes that the entity that must be paid theobligation will not cancel the financial institutions obligation prior to any actual or pro-jected payout date.The descriptions of cash outlays as either known or uncertain are undoubtedly broad.When we refer to a cash outlay as being uncertain, we do not mean that it cannot be pre-dicted. There are some liabilities where thelaw of large numbers makes it easier to predictthe timing and/or amount of cash outlays. This is the work typically done by actuaries,but of course even actuaries cannot predict natural catastrophes such as floods andearthquakes.As we describe the various financial institutions in later chapters, keep these risk cate-gories in mind. For now, lets illustrate each oneType-I LiabilitiesBoth the amount and the timing of the liabilities are known with certainty. A liabilityrequiring a financial institution to pay $50,000 six months from now would be an example.For example, depository institutions know the amount that they are committed to pay(principal plus interest) on the maturity date of a fixed-rate deposit, assuming that .thedepositor does not withdraw funds prior to the maturity date.Tble 241Nature of Llabillties of Financial InstitutionsLiability TypeAmount of Cash OutlayTiming of Cash OutlayType IType llType InType IVKnownKnownUncertainUncertainKnownUncertainKnownUncertain26 | Parol IntroductionType-1 liabilities, however, are not limited to depository institutions. A major productsold by life insurance companies is a guaranteed investment contract, popularly referredto as a GIC. The obligation of the life insurance company under this contract is that, for asum of money (called a premium), it will guarantee 'an interest rate up to some specifiedmaturity date. For example, suppose a life insurance company for a premium of $10 mil~lion issues a five-year GIC agreeing to pay 10% compounded annually. The life insurancecompany knows that it must pay $16.1 1 million to the GIC policyholder in five years?Type-II LiabilitiesThe amount of cash outlay is known, but the timing of the cash outlay is uncertain. Themost obvious example of a Type-II liability is a life insurance policy. There are many typesof life insurance policies that we shall discuss in Chapter 6, but the most basic type is that,for an annual premium, a life insurance company agrees to make a speciEed dollar pay-ment to policy beneficiaries upon the death of the insured.Type-III LiabilitiesWith this type of liability, the timing of the cash outlay is known, but the amount isuncertain.An example is where a Enancial institution has issued an obligation in which theinterest rate adjusts periodically according to some interest rate benchmark. Depositoryinstitutions, for example, issue accounts called certificates of deposit (CD), which have astated maturity. The interest rate paid need not be fixed over the life of the deposit but mayfluctuate. If a depository institution issues a three-year floating-rate certificate of depositthat adjusts every three months and the interest rate paid is the three-month Treasury billrate plus one percentage point, the depository institution knows it has a liability that mustbe paid off in three years, but the dollar amount of the liability is not known. It will dependon three-month Treasury bill rates over the three years.Type-IV LiabilitiesThere are numerous insurance products and pension obligations that present uncertainty as toboth the amount and the timing of the cash outlay. Probably the most obvious examples areautomobile and home insurance policies issued by property and casualty insurance compa-nies. When, and if, a payment will have to be made to the policyholder is uncertain. Wheneverdamage is done to an insured asset, the amount of the payment that must be made is uncenain.As we explain in Chapter 8, sponsors of pension plans can agree to various types ofpension obligations to the benehcia ries of the plan. There are plans where retirement ben-efits depend on the participants income for a specified number of years before retirementand the total number of years the participant worked. This will affect the amount of thecash outlay. The timing of the cash outlay depends on when the employee elects to retire,and whether or not the employee remains with the sponsoring plan until retirement.Moreover, both the amount and the timing will depend on how the employee elects to havepayments made-over only the employees life or those of the employee and spouse.1 A GIC does not seem like a product that we would associate with a life insurance company because :he policy-holder does not have to die in order for someone to be paid. Yet as we shall see when we discuss life insurancecompanies in Chapter 6, a major group of insurance company linancia1 products is in lhe pension benefit area.A GIC is one such product.z This amount is determined as follows: $10,000,000 (l.l0)5.Chapter ZFinancial Institutions, Financial Intermediaries, and Asset Management Firms I 27Liquidity ConcernsBecause of uncertainty about the timing and/or the amount of the cash outlays, a Hnancialinstitution must be prepared to have sufficient cash to satisfy its obligations. Also keep in mindthat our discussion of liabilities assumes dial the entity that holds the obligation against thelinancid institution may have the right to change the nature of the obligation, perhaps incur-ring some penalty. For example, in the case of a ver tificate of deposit, the depositor may requestthe withdrawal of funds prior to the maturity date. Typically, the deposit-accepting institutionwill grant this request but assess an early withdrawal penalty. ln the case of certain types ofinvestment companies, shareholders have the right to redeem their shares at any time,Some life insurance products have a cash-surrender value. This mea ns that, at specifieddates, the policyholder can exchange the policy for a lump-sum payment. Typically, thelump-sum payment will penalize the policyholder for turning in the policy. There are somelife insurance products that have a loan value, which means that the policyholder has theright to borrow against the cash value of the policy.In addition to uncertainty about the timing and amount of the cash outlays, and thepotential for the depositor or policyholder to withdraw cash early or borrow against a policy,a 'financial institution has to be concerned with possible reduction in cash inflows. In thecase of a depository institution, this means the inability to obtain deposits. For insurancecompanies, it means reduced premiums because of' the cancellation of policies. For certaintypes of investment companies, it means not being able to find new buyers for shares.Regulations and TaxationNumerous regulations and tax considerations influence the investment policies that finan-cial institutions pursue. When we discuss the various financial institutions in later chapters,we will highlight the key regulations and tax Rectors.-1Key Points That You Should Understand Before Proceeding3.The two dlmenslons of the habllms ofa financial institution: amount of the cashoutlay and the timing of the cash outlay.Why a Enancial institution must be prepared to have sufficient cash to satisfy iliabilities.I CONCERNS OF REGULATORSIn the previous chaptenwe discussed the role of the govern ment in the regulation of financialmarkets. Here, we will provide a brief discussion of the risks that regulators have regardingEnancid institutions. These risks can he classified into the following sources of risk:| credit riskn settlement risk market risk| liquidity risk| operational risk legal risk1. What is meant by a financial institution being in the spread business.2.i28 | Parti IntroductionCredit risk is a broadly used term to describe several types of risk, ln terms of regulatoryconcerns, credit risk is the risk that the obligor of a Hnancial instrument held. by a financialinstitution will fail to fulhll its obligation on the due date or at any time thereafter.According to the International Financial Risk Institute, settlement risk is the risk thatwhen there is a settlement of a trade or obligation, the transfer fails to take place asexpected. Settlement risk consists of counterparts risk (a form of credit risk) and a form ofliquidity risk.Counterparty risk is the risk that a counterparts in a trade fails to satisfy its obligation.The trade could involve the cash settlement of a contract or the physical delivery of someasset. Liquidity risk in the context of settlement risk means that the counterparts can even-tually meet its obligation, but not at the due date. As a result, the party failing to receivetimely payment must be prepared to finance any shortfall in the contractual payment.Market risk is the risk to a financial institution's economic well-being that results froman.. adverse movement in the market price of assets (debt obligations, equities, commodi-ties, currencies) it owns or the level or the volatility of market prices. There are measuresthat can be used to gauge this risk. One such measure endorsed by bank regulators is vdue-at-risk, a measure of the potential loss in a financial institutions financial position associ-ated with an adverse price movement of a given probability over a specihed time horizon.Liquidity risk, in addition to being a part of settlement risk, has two forms according tothe International Financial Risk Institute. The first is the risk that a financial institution isunable to transact in a Enancial instrument at a price near its market value. This risk iscalled market liquidity risk. The other form of liquidity risk is funding liquidity risk. Thisis the risk that the financial institution will be unable to obtain funding to obtain cash flownecessary to satisfy its obligations.An important risk that is often overlooked but has been the cause of the demise ofsome major financial institutions is operational risk. Well-known examples in the past twodeca des include Orange County (1994, United States), Barings Bank (1995, UnitedKingdom), Daiwa Bank (1995, New York), Allied Irish Banks (2002, Ireland), Enron (2001,United States), MasterCard International (2005, United States), and the terrorist attack inNew York on September 11, 2001.3 Operations risk is defined by bank regulators astherisk of loss resulting from inadequate or failed internal processes, people and systems, orfrom external events. The definition of operation risk includes legd risk This is the riskof loss resulting from failure to comply with laws as well as prudent ethical standards andcontractual obligations.The Global Association of Risk Professionals (GARP) suggests classifying the majorcategories of operational risk according to the cause of the loss event as follows:1. employee: loss events resulting from the actions or inactions of a person who worksfor a firm2. business process: loss events arising from a firms execution of business operations3 For a description of each of these examples, see Chapter 1 in Anna Chernobui, Svetlozar TI Rachev, and Frank I.Faboui, Operational RislcA Guide to Basel H Capital Requirements. Models and Analysis /Hoboken, N): JohnWiley & Sons, 2007).4 This is the common industry definition that has been adopted by the Bank for International Settlements. SeeBasel Committee on Banking Supervision, Operational Risk, Consultative Document, Bank for InternationalSettlements, lanuary 200] .,yChapter 2 Finandal Institutions, Financial Intermediaries, and Asset Management Firms | 293. relationships: loss events caused by the connection or contact that a Hem has withclients, regulators, or third parties. This category focuses on the interaction between afirm and other entities; relationship risks involve both parties4. technology: loss events due to piracy, theft, failure, breakdown, or other disruption intechnology, data or information. This category also includes technology that fails tomeet the intended business needs5. external: loss events caused by people or entities outside a hem, the firm cannot con-trol their actions5The Hve categories above apply to nonfinancial entities as well as financial institutions.Several reports by regulators have recommended guidelines for controlling the risksof financial institutions described above. One key report is theDerivatives: Practicesand Principles prepared by the Group of 30 in 1993.6-7 Derivatives are used to controlrisks. Their use by end-users such as financial institutions and by dealers (commercialbanks and investment banking firms) that are the counterparts for many types of deriv-atives is of great concern to regulators. As indicated by its title, the focus of the Group of30 report is on derivatives. The report provides guidelines to help financial institutionsand dealers in derivatives to manage derivatives activity in order to benefit from the useof these derivatives.These guidelines fall into five categories: (1) general policies for senior management;(2) valuation and market risk management; (3) credit risk measurement and management;(4) systems, operations, and control; and (5) recommendations for legislators, regulators,and supervisors.We will continue our discussion of risks financial institutions face and guidelines fordealing with them when we discuss depository institutions in Chapter 3.Key Points That You Should Understand Before Proceeding1. The concerns of regulators involve credit risk, settlement risk, market risk, liquidity lrisk, operational risk, and legal risk. l2. Several reports by regulators have recommended guidelines for controlling the risksof financial institutions. :_JlIASSET MANAGEMENT FIRMSAsset management firms manage the finds of individuals, businesses, endowments andfoundations, and state and local governments. These Ems are also referred to as moneymanagement firms and fund management firms and those who manage the funds arereferred to as asset managers, money managers, fund managers, and portfolio l`llli\lll3gl'S.5 Gene /il\'arez.Operatinnal Risk Event CIassiE:::ttion, published on the GARP website, ww\\'.g:trp.cnn\.6 The Gnvnp nf 39 is a private, nonproht international Organization seeking to "deepen understanding ofinternational econnmia: and Iinanuinl issues, to explore the international repercussions nfdecisions taken in thepublic and private sectors, and to examine the choices availatble to market practitioners and polio-makers.7 Two other key reports are theRisk Management Guidelines for Derivatives" prepared jointly hy thc BaselCommittee on Banking Supervision of the Bank of international Settlements and the International (rganisationof Securities Commissions in 1994 andFmmework for the Evaluation ol' internal Control Systems" prepatretl hythe BIS in 1998.30 | Parti IntroductionAsset management Hrms are either affiliated with some financial institution (such as acommercial bank, insurance company, or investment bank) or are independent companies.Larger institutional clients seeking the services of an asset management firm typicallydo not allocate all of their assets to one asset management firm. Instead, they typicallydiversify amongst several asset management firms, as well as possibly managing some por~ton of their funds internally. One reason for using several asset management firms is thatfirms differ in their expertise with respect to asset classes. For example, a client that seeks anasset manager to invest in common stock, bonds, real estate, and alternative investments(such as commodities and hedge funds) will use asset management firms that specialize ineach of those asset classes.Asset management firms are ranked annually by Pension ' "9 4~!osito ry Institutions,Federal Reselrve,Monetary Pollcy*.. 9~e mi MZ"LEARNING OBJECTIVESAfter reading this chapter, you will understand the role of depository institutions how a depository institution generates income- differences among commercial banks, savings and loan assodations, savings banks, andcredit unions the asset/liability problem all depository institutions face who regulates commercial banks and thrifts and the types of regulations imposed- the funding sources available to commercial banks and thrifts the capital requirements imposed on commercial banks and savings and loan associations what are the Basel I and Basel ll frameworksepository institutions include commercial banks (or simply banks), savings and loanD associations (S8. .Fifth Third Bancorp (Cincinnati, Ohio) Keycorp- (Cleveland, Ohio)Bancwest Corp. (Honolulu,I-Iawaii)Harris Finandad Corp..(W1lmington, Del.)-Nonhem Test Corp. (Chicago, lll.).Comericailncorporated (Dallas, 'ivm' rMarshall 8: llsley Corp. (Milwaukee, Wis.) Eigcsfp; 1BW,NL1)Union Bank of Calif. (San Francisco, Calif.)jCliai1s:$chwab Corp. (San Francisco, Caliifl) `Zions Bancorporation (Salt lake City, Utah)Commerce Bancorp, Inc. (Cherry Hill, NJ.)Popular, Inc. (San Juan, Pueno Rico)579,062539,865483,630222,530180,314160,341159,392145,937140,648137,624127,577125,736112,345101,38993,49070,66164,47559,60958,94558,327.5786953,17348,7038,23146,985Note: As ofSeptember 30. 2007.Source' Federal Reserve System, National Information Center:Bank ServicesCommercial banks provide numerous services in our financed system. The services canbe broadly classified as follows: (1) individual banking, (2) institutional banldng, and(3) global banldng. Of course, different banks are more active in certain of these activitiesthan others. For example, money center banks (defined later) are more active in globalbanking,Rank Name (City, State)Consolidated Assets1.2.3.cifigropp (New Yxk,N;y.)Bank of America Corp. (Charlotte, N.C.)].R Morgan Chase 8: Company (Columbus, Ohio)$2,220,8661,535,6841,458,0427 1 9,9224.Wachovia Corp, (Charlotte, N.C.)Chapter3 Depositorylnstitutions:Activities and Characteristics | 45Individual banking encompasses consumer lending, residential mortgage lending,consumer instillment loans, credit card Hnancing, automobile and boat financing, bro-kerage services, student loans, and individual-oriented Hnancial investment services suchas personal trust and investment services. Interest income and fee income are generatedfrom mortgage lending and credit card Hnancing. Mortgage lending is more popularlyreferred to as mortgage banking. We will discuss this activity and how fee income is gen-erated in Chapter 22. Fee income is generated from brokerage services and financialinvestment services.Loans to nonlinancial corporations, financial corporations (such as life insurance com-panies), and govemment entities (state and local governments in the United States and for-eign governments) fall into the category of institutional banking. Also included in this cate-gory are commercial real estate financing, leasing activities? and factoring? In the case ofleasing, a bank may be involved in leasing equipment either as lessors! as lenders to lessorS,or as purchasers ofleases. Loans and leasing generate interest income, and other services thatbanks offer institutional customers gener