chapter+1+why+study+financial+markets+and+institutions

Why Study FinancialMarkets and Institutions?

PreviewOn the evening news you have just heard that the bond market has beenbooming. Does this mean that interest rates will fall so that it is easier for youto finance the purchase of a new computer system for your small retail busi-ness? Will the economy improve in the future so that it is a good time tobuild a new building or add to the one you are in? Should you try to raisefunds by issuing stocks or bonds, or instead go to the bank for a loan? If youimport goods from abroad, should you be concerned that they will becomemore expensive?

This book provides answers to these questions by examining how financialmarkets (such as those for bonds, stocks, and foreign exchange) and financialinstitutions (banks, insurance companies, mutual funds, and other institutions)work. Financial markets and institutions not only affect your everyday life butalso involve huge flows of fundstrillions of dollarsthroughout our economy,which in turn affect business profits, the production of goods and services, andeven the economic well-being of countries other than the United States. Whathappens to financial markets and institutions is of great concern to politiciansand can even have a major impact on elections. The study of financial marketsand institutions will reward you with an understanding of many exciting issues.In this chapter we provide a road map of the book by outlining these excitingissues and exploring why they are worth studying.

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1C H A P T E RPA RT O N E I N T R O D U C T I O N

Why Study Financial Markets?Parts 2 and 5 of this book focus on financial markets, markets in which funds aretransferred from people who have an excess of available funds to people who havea shortage. Financial markets, such as bond and stock markets, are crucial to pro-moting greater economic efficiency by channeling funds from people who do not havea productive use for them to those who do. Indeed, well-functioning financial mar-kets are a key factor in producing high economic growth, and poorly performing finan-cial 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 behav-ior of businesses and consumers, and the cyclical performance of the economy.

Debt Markets and Interest RatesA security (also called a financial instrument) is a claim on the issuers futureincome or assets (any financial claim or piece of property that is subject to owner-ship). A bond is a debt security that promises to make payments periodically fora specified period of time.1 Debt markets, also often referred to generically as thebond market, are especially important to economic activity because they enable cor-porations and governments to borrow in order to finance their activities; the bondmarket is also where interest rates are determined. An interest rate is the costof borrowing or the price paid for the rental of funds (usually expressed as a per-centage of the rental of $100 per year). There are many interest rates in the econ-omymortgage interest rates, car loan rates, and interest rates on many differenttypes of bonds.

Interest rates are important on a number of levels. On a personal level, high inter-est rates could deter you from buying a house or a car because the cost of financ-ing it would be high. Conversely, high interest rates could encourage you to savebecause you can earn more interest income by putting aside some of your earningsas savings. On a more general level, interest rates have an impact on the overall healthof the economy because they affect not only consumers willingness to spend orsave but also businesses investment decisions. High interest rates, for example, mightcause a corporation to postpone building a new plant that would provide more jobs.

Because changes in interest rates have important effects on individuals, finan-cial institutions, businesses, and the overall economy, it is important to explain fluc-tuations in interest rates that have been substantial over the past 20 years. Forexample, 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 themid to late 1990s. It then fell below 1% in 2004, rose to 5% by 2007, only to fall tozero in 2008 where it remained close to that level into 2010.

Because different interest rates have a tendency to move in unison, economistsfrequently lump interest rates together and refer to the interest rate. As Figure 1.1shows, however, interest rates on several types of bonds can differ substantially.The interest rate on three-month Treasury bills, for example, fluctuates more thanthe 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

2 Part 1 Introduction

http://www.federalreserve.gov/econresdata/releases/statisticsdata.htmAccess daily, weekly,monthly, quarterly, andannual releases andhistorical data for selectedinterest rates, foreignexchange rates, and so on.

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1The 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 financialmarkets use the word bond to describe only specific long-term debt instruments such as corporatebonds or U.S. Treasury bonds.

Chapter 1 Why Study Financial Markets and Institutions? 3

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1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

InterestRate (%)

U.S. GovernmentLong-Term Bonds

Corporate Baa Bonds

Three-MonthTreasury Bills

F I G U R E 1 . 1 Interest Rates on Selected Bonds, 19502010

Sources: Federal Reserve Bulletin; www.federalreserve.gov/releases/H15/data.htm.

the spread between it and the other rates became larger in the 1970s, narrowed inthe 1990s and particularly in the middle 2000s, only to surge to extremely high lev-els during the financial crisis of 20072009 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 commonmovements in interest rates come about, and why the interest rates on differentbonds vary.

The Stock MarketA common stock (typically just called a stock) represents a share of ownership ina corporation. It is a security that is a claim on the earnings and assets of the corpo-ration. Issuing stock and selling it to the public is a way for corporations to raise fundsto finance their activities. The stock market, in which claims on the earnings of cor-porations (shares of stock) are traded, is the most widely followed financial marketin almost every country that has one; thats 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 theevening news. People often speculate on where the market is heading and get veryexcited when they can brag about their latest big killing, but they become depressedwhen they suffer a big loss. The attention the market receives can probably be bestexplained by one simple fact: It is a place where people can get richor poorquickly.

As Figure 1.2 indicates, stock prices are extremely volatile. After the market rosein 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) fallingby 22%. From then until 2000, the stock market experienced one of the great bullmarkets in its history, with the Dow climbing to a peak of over 11,000. With the col-lapse of the high-tech bubble in 2000, the stock market fell sharply, dropping byover 30% by late 2002. It then recovered again, reaching the 14,000 level in 2007, onlyto fall by over 50% of its value to a low below 7,000 in 2009. These considerable

http://stockcharts.com/charts/historical/Access historical charts ofvarious stock indexes overdiffering time periods.

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01950 1955 1960 1965 1970 1975 1980 1985 1990 2000 20051995

2,000

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14,000

2010

Dow JonesIndustrial Average

F I G U R E 1 . 2 Stock Prices as Measured by the Dow Jones Industrial Average, 19502010

Source: Dow Jones Indexes: http://finance.yahoo.com/?u.

fluctuations in stock prices affect the size of peoples wealth and as a result may affecttheir 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 sell-ing newly issued stock to finance investment spending. A higher price for a firmsshares means that it can raise a larger amount of funds, which can be used to buyproduction facilities and equipment.

In Chapter 2 we examine the role that the stock market plays in the financial sys-tem, and we return to the issue of how stock prices behave and respond to infor-mation in the marketplace in Chapters 6 and 13.

The Foreign Exchange MarketFor funds to be transferred from one country to another, they have to be convertedfrom the currency in the country of origin (say, dollars) into the currency of the coun-try they are going to (say, euros). The foreign exchange market is where this


1970 1975 1980 1985 1990 1995 2000 2005

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105

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Index(March 1973 = 100)

F I G U R E 1 . 3 Exchange Rate of the U.S. Dollar, 19702010

Source: www.federalreserve.gov/releases/H10/summary/indexbc_m.txt.

conversion takes place, so it is instrumental in moving funds between countries. Itis also important because it is where the foreign exchange rate, the price of onecountrys currency in terms of anothers, is determined.

Figure 1.3 shows the exchange rate for the U.S. dollar from 1970 to 2010 (mea-sured as the value of the U.S. dollar in terms of a basket of major foreign curren-cies). The fluctuations in prices in this market have also been substantial: The dollarsvalue weakened considerably from 1971 to 1973, rose slightly until 1976, and thenreached a low point in the 19781980 period. From 1980 to early 1985, the dollarsvalue appreciated dramatically, and then declined again, reaching another low in1995. The dollar appreciated from 1995 to 2000, only to depreciate thereafter untilit recovered some of its value starting in 2008.

What have these fluctuations in the exchange rate meant to the American pub-lic and businesses? A change in the exchange rate has a direct effect on American con-sumers because it affects the cost of imports. In 2001, when the euro was worth around85 cents, 100 euros of European goods (say, French wine) cost $85. When the dol-lar subsequently weakened, raising the cost of a euro to $1.50, the same 100 eurosof 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 yourdesire for imported delicacies. When the value of the dollar drops, Americansdecrease their purchases of foreign goods and increase their consumption of domes-tic 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 morein foreign countries, and hence foreigners will buy fewer of them. Exports of steel,for example, declined sharply when the dollar strengthened in the 19801985 and19952001 periods. A strong dollar benefited American consumers by making for-eign goods cheaper but hurt American businesses and eliminated some jobs by cut-ting both domestic and foreign sales of their products. The decline in the value ofthe dollar from 1985 to 1995 and 2001 to 2007 had the opposite effect: It madeforeign goods more expensive, but made American businesses more competitive.Fluctuations in the foreign exchange markets thus have major consequences for theAmerican economy.

In Chapter 15 we study how exchange rates are determined in the foreignexchange 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 arewhat make financial markets work. Without them, financial markets would not be ableto move funds from people who save to people who have productive investment oppor-tunities. They thus play a crucial role in improving the efficiency of the economy.

Structure of the Financial SystemThe financial system is complex, comprising many different types of private-sectorfinancial institutions, including banks, insurance companies, mutual funds, financecompanies, and investment banksall of which are heavily regulated by the govern-ment. If you wanted to make a loan to IBM or General Motors, for example, you wouldnot go directly to the president of the company and offer a loan. Instead, you wouldlend to such companies indirectly through financial intermediaries, institutionssuch as commercial banks, savings and loan associations, mutual savings banks, creditunions, insurance companies, mutual funds, pension funds, and finance companiesthat 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 writecomplicated legal documents when they extend loans? Why are they the most heav-ily regulated businesses in the economy?

We answer these questions by developing a coherent framework for analyz-ing financial structure both in the United States and in the rest of the world inChapter 7.

Financial CrisesAt times, the financial system seizes up and produces financial crises, majordisruptions in financial markets that are characterized by sharp declines in assetprices and the failures of many financial and nonfinancial firms. Financial criseshave been a feature of capitalist economies for hundreds of years and are typicallyfollowed by the worst business cycle downturns. From 2007 to 2009, the U.S. economy was hit by the worst financial crisis since the Great Depression. Defaultsin subprime residential mortgages led to major losses in financial institutions, producing not only numerous bank failures, but also leading to the demise ofBear Stearns and Lehman Brothers, two of the largest investment banks in theUnited States.

Why these crises occur and why they do so much damage to the economy isdiscussed in Chapter 8.

Central Banks and the Conduct of Monetary PolicyThe most important financial institution in the financial system is the central bank,the government agency responsible for the conduct of monetary policy, which inthe United States is the Federal Reserve System (also called simply the Fed).Monetary policy involves the management of interest rates and the quantity ofmoney, also referred to as the money supply (defined as anything that is gener-ally 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


www.federalreserve.govAccess generalinformation as well asmonetary policy, bankingsystem, research, andeconomic data of theFederal Reserve.

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which have a major impact on financial markets and institutions, we study how mon-etary policy is conducted by central banks in both the United States and abroad inChapters 9 and 10.

The International Financial SystemThe tremendous increase in capital flows between countries means that the inter-national financial system has a growing impact on domestic economies. Whether acountry fixes its exchange rate to that of another is an important determinant ofhow monetary policy is conducted. Whether there are capital controls that restrictmobility of capital across national borders has a large effect on domestic financialsystems and the performance of the economy. What role international financial insti-tutions such as the International Monetary Fund should play in the international finan-cial system is very controversial. All of these issues are explored in Chapter 16.

Banks and Other Financial InstitutionsBanks are financial institutions that accept deposits and make loans. Included underthe term banks are firms such as commercial banks, savings and loan associations,mutual savings banks, and credit unions. Banks are the financial intermediaries thatthe average person interacts with most frequently. A person who needs a loan to buya house or a car usually obtains it from a local bank. Most Americans keep a largeproportion of their financial wealth in banks in the form of checking accounts, sav-ings accounts, or other types of bank deposits. Because banks are the largest finan-cial intermediaries in our economy, they deserve careful study. However, banks are notthe only important financial institutions. Indeed, in recent years, other financial insti-tutions 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 tostudy them as well. We study banks and all these other institutions in Parts 6 and 7.

Financial InnovationIn the good old days, when you took cash out of the bank or wanted to check youraccount balance, you got to say hello to a friendly human. Nowadays, you are more likelyto interact with an automatic teller machine (ATM) when withdrawing cash, and touse your home computer to check your account balance. To see why these options havedeveloped, we study why and how financial innovation takes place in Chapter 19, withparticular emphasis on how the dramatic improvements in information technology haveled to new means of delivering financial services electronically, in what has becomeknown as e-finance. We also study financial innovation because it shows us how cre-ative thinking on the part of financial institutions can lead to higher profits. By seeinghow and why financial institutions have been creative in the past, we obtain a bettergrasp of how they may be creative in the future. This knowledge provides us with use-ful clues about how the financial system may change over time and will help keep ourunderstanding about banks and other financial institutions from becoming obsolete.

Managing Risk in Financial InstitutionsIn recent years, the economic environment has become an increasingly risky place.Interest rates have fluctuated wildly, stock markets have crashed both here andabroad, speculative crises have occurred in the foreign exchange markets, and failures


of financial institutions have reached levels unprecedented since the GreatDepression. To avoid wild swings in profitability (and even possibly failure) result-ing from this environment, financial institutions must be concerned with how to copewith increased risk. We look at techniques that these institutions use when theyengage in risk management in Chapter 23. Then in Chapter 24, we look at how theseinstitutions make use of new financial instruments, such as financial futures, options,and swaps, to manage risk.

Applied Managerial PerspectiveAnother reason for studying financial institutions is that they are among the largestemployers in the country and frequently pay very high salaries. Hence, some of youhave a very practical reason for studying financial institutions: It may help you geta good job in the financial sector. Even if your interests lie elsewhere, you should stillcare about how financial institutions are run because there will be many times in yourlife, as an individual, an employee, or the owner of a business, when you will inter-act with these institutions. Knowing how financial institutions are managed may helpyou get a better deal when you need to borrow from them or if you decide to sup-ply them with funds.

This book emphasizes an applied managerial perspective in teaching you aboutfinancial markets and institutions by including special case applications headed ThePracticing Manager. These cases introduce you to the real-world problems that man-agers of financial institutions commonly face and need to solve in their day-to-dayjobs. For example, how does the manager of a financial institution come up with anew financial product that will be profitable? How does a manager of a financial insti-tution 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 FederalReserve policy making, referred to as a Fed watcher, to help the institution dis-cern where monetary policy might be going in the future?

Not only do The Practicing Manager cases, which answer these questions andothers like them, provide you with some special analytic tools that you will need ifyou make your career at a financial institution, but they also give you a feel for whata job as the manager of a financial institution is all about.

How We Will Study Financial Markets and InstitutionsInstead of focusing on a mass of dull facts that will soon become obsolete, this text-book emphasizes a unifying, analytic framework for studying financial markets andinstitutions. This framework uses a few basic concepts to help organize your think-ing about the determination of asset prices, the structure of financial markets, bankmanagement, and the role of monetary policy in the economy. The basic concepts areequilibrium, basic supply and demand analysis to explain behavior in financial mar-kets, the search for profits, and an approach to financial structure based on trans-action costs and asymmetric information.

The unifying framework used in this book will keep your knowledge from becom-ing obsolete and make the material more interesting. It will enable you to learn whatreally matters without having to memorize material that you will forget soon afterthe final exam. This framework will also provide you with the tools needed to under-stand trends in the financial marketplace and in variables such as interest rates andexchange rates.


To help you understand and apply the unifying analytic framework, simple mod-els are constructed in which the variables held constant are carefully delineated, eachstep in the derivation of the model is clearly and carefully laid out, and the modelsare then used to explain various phenomena by focusing on changes in one variableat a time, holding all other variables constant.

To reinforce the models usefulness, this text also emphasizes the interactionof theoretical analysis and empirical data in order to expose you to real-life eventsand data. To make the study of financial markets and institutions even more rele-vant and to help you learn the material, the book contains, besides The PracticingManager cases, numerous additional cases and mini-cases that demonstrate how youcan 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 thetools to follow the financial news that appears in leading financial publications. Tohelp and encourage you to read the financial section of the newspaper, this book con-tains two special features. The first is a set of special boxed inserts titled Followingthe Financial News that contain actual columns and data from the Wall StreetJournal (subscription required on the Web at http://online.wsj.com/home-page) or thatare found in other financial publications or Web sites that appear daily or periodically.These boxes give you the detailed information and definitions you need to evaluatethe data being presented. The second feature is a set of special case applications titledReading the Wall Street Journal that expand on the Following the FinancialNews boxes. These cases show you how you can use the analytic framework in thebook directly to make sense of the daily columns in the United States leading finan-cial newspaper. In addition to these cases, this book also contains nearly 400 end-of-chapter problems that ask you to apply the analytic concepts you have learnedto other real-world issues. Particularly relevant is a special class of problems headedPredicting the Future. These questions give you an opportunity to review and applymany of the important financial concepts and tools presented throughout the book.

Exploring the WebThe World Wide Web has become an extremely valuable and convenient resourcefor 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 thatappear throughout the text, we include the source sites URL. These sites often con-tain additional information and are updated frequently. Second, we have added Webexercises to the end of each chapter. These exercises prompt you to visit sites relatedto the chapter and to work with real-time data and information. We have also addedWeb references to the end of each chapter that list the URLs of sites related to thematerial being discussed. Visit these sites to further explore a topic you find of par-ticular interest. Web site URLs are subject to frequent change. We have tried to selectstable sites, but we realize that even government URLs change. The publishers Website (www.pearsonhighered.com/mishkin_eakins) will maintain an updated list of cur-rent URLs for your reference.

Collecting and Graphing DataThe following Web exercise is especially important because it demonstrates how toexport data from a Web site into Microsoft Excel for further analysis. We suggestyou work through this problem on your own so that you will be able to perform thisactivity when prompted in subsequent Web exercises.


Web ExerciseYou have been hired by Risky Ventures, Inc., as a consultant to help the company ana-lyze interest-rate trends. Your employers are initially interested in determining thehistorical relationship between long- and short-term interest rates. The biggest taskyou must immediately undertake is collecting market interest-rate data. You knowthe best source of this information is the Web.

1. You decide that your best indicator of long-term interest rates is the 10-yearU.S. Treasury note. Your first task is to gather historical data. Go towww.federalreserve.gov/releases/H15. The site should look like Figure 1.4. Atthe top, click HISTORICAL DATA. Now scroll down to Treasury ConstantMaturities, and click on the ANNUAL TAG to the right of the 10 Year category.

F I G U R E 1 . 4 Federal Reserve Web Site for Selected Interest Rates

Source: www.federalreserve.gov.


F I G U R E 1 . 5 Excel Spreadsheet with Interest-Rate Data

Source: Used with permission from Microsoft

2. Now that you have located an accurate source of historical interest-rate data,the next step is getting it onto a spreadsheet. Excel will let you convert textdata into columns. Begin by highlighting the two columns of data (the yearand rate). Right-click and choose COPY. Now open Excel and put the cursorin a cell. Click PASTE. Now choose data from the menu bar and click TEXT TOCOLUMNS. Follow the wizard (Figure 1.5), checking the fixed-width option. Thelist of interest rates should now have the year in one column and the inter-est rate in the next column. Label your columns.

Repeat the preceding steps to collect the one-year interest rate series.Put it in the column next to the 10-year series. Be sure to line up the yearscorrectly and delete any years that are not included in both series.

3. You now want to analyze the interest rates by graphing them. Highlight thetwo columns of interest-rate data you just created in Excel. Click on theCHART WIZARD ICON on the toolbar (or INSERT/CHART). Select the Scatter charttype, and choose any type of scatter chart subtype that connects the dots.Let the Excel wizard take you through the steps of completing the graph.(See Figure 1.6.)


S U M M A R Y

1. Activities in financial markets have direct effects onindividuals wealth, the behavior of businesses, and theefficiency of our economy. Three financial marketsdeserve particular attention: the bond market (whereinterest rates are determined), the stock market(which has a major effect on peoples wealth and onfirms investment decisions), and the foreign exchange

market (because fluctuations in the foreign exchangerate have major consequences for the U.S. economy).

2. Because monetary policy affects interest rates, infla-tion, and business cycles, all of which have an impor-tant impact on financial markets and institutions, weneed to understand how monetary policy is conductedby central banks in the United States and abroad.

F I G U R E 1 . 6 Excel Graph of Interest-Data

Source: Used with permission from Microsoft

Concluding RemarksThe field of financial markets and institutions is an exciting one. Not only will youdevelop skills that will be valuable in your career, but you will also gain a clearerunderstanding of events in financial markets and institutions you frequently hearabout in the news media. This book will introduce you to many of the controver-sies that are hotly debated in the current political arena.


K E Y T E R M S

asset, p. 2banks, p. 7bond, p. 2central bank, p. 6common stock (stock), p. 3e-finance, p. 7

Federal Reserve System (the Fed), p. 6

financial crises, p. 6financial intermediaries, p. 6financial markets, p. 2foreign exchange market, p. 4

foreign exchange rate, p. 5interest rate, p. 2monetary policy, p. 6money (money supply), p. 6security, p. 2

Q U E S T I O N S

1. Why are financial markets important to the health ofthe economy?

2. When interest rates rise, how might businesses andconsumers change their economic behavior?

3. How can a change in interest rates affect the prof-itability of financial institutions?

4. Is everybody worse off when interest rates rise?

5. What effect might a fall in stock prices have on busi-ness investment?

6. What effect might a rise in stock prices have on con-sumers decisions to spend?

7. How does a decline in the value of the pound ster-ling affect British consumers?

8. How does an increase in the value of the pound ster-ling affect American businesses?

9. How can changes in foreign exchange rates affect theprofitability of financial institutions?

10. Looking at Figure 1.3, in what years would you havechosen to visit the Grand Canyon in Arizona ratherthan the Tower of London?

11. What is the basic activity of banks?

12. What are the other important financial intermediariesin the economy besides banks?

13. Can you think of any financial innovation in the past10 years that has affected you personally? Has it madeyou better or worse off? In what way?

14. What types of risks do financial institutions face?

15. Why do managers of financial institutions care somuch about the activities of the Federal ReserveSystem?

3. Banks and other financial institutions channel fundsfrom people who might not put them to productiveuse to people who can do so and thus play a crucialrole in improving the efficiency of the economy.

4. Understanding how financial institutions are managedis important because there will be many times in yourlife, as an individual, an employee, or the owner of abusiness, when you will interact with them. ThePracticing Manager cases not only provide special

analytic tools that are useful if you choose a careerwith a financial institution but also give you a feel forwhat a job as the manager of a financial institutionis all about.

5. This textbook emphasizes an analytic way of thinkingby developing a unifying framework for the study offinancial markets and institutions using a few basicprinciples. This textbook also focuses on the inter-action of theoretical analysis and empirical data.


W E B E X E R C I S E S

Working with Financial Market Data

1. In this exercise we will practice collecting data fromthe Web and graphing it using Excel. Use the exam-ple on pages 1012 as a guide. Go to www.forecasts.org/data/index.htm, click on Data at the top of thepage, click on Stock Index Data, and choose theU.S. Stock IndicesMonthly option. Finally, choosethe Dow Jones Industrial Average option.

a. Using the method presented in this chapter, movethe data into an Excel spreadsheet.

b. Using the data from step a, prepare a chart. Usethe Chart Wizard to properly label your axes.

2. In Web Exercise 1 you collected and graphed the DowJones Industrial Average. This same site reports fore-cast values of the DJIA. Go to www.forecasts.org/data/index.htm. Click the Dow Jones Industrials linkunder 6 Month Forecasts in the far-left column.

a. What is the Dow forecast to be in six months?

b. What percentage increase is forecast for the nextsix months?

Date U.S. Dollars per GBP

4/1 1.95644/4 1.92934/5 1.9144/6 1.93744/7 1.9614/8 1.89254/11 1.88224/12 1.85584/13 1.7964/14 1.79024/15 1.77854/18 1.75044/19 1.72554/20 1.69144/21 1.6724/22 1.66844/25 1.66744/26 1.68574/27 1.69254/28 1.72014/29 1.7512

Q U A N T I TAT I V E P R O B L E M S

1. The following table lists foreign exchange ratesbetween U.S. dollars and British pounds (GBP) dur-ing April.

Which day would have been the best day to convert$200 into British pounds? Which day would have beenthe worst day? What would be the difference in pounds?

CoverTitle PageCopyright PageContentsContents on the WebPrefaceA Note from Frederic MishkinWhats New in the Seventh EditionHallmarksFlexibilityMaking It Easier to Teach Financial Markets and InstitutionsPedagogical AidsSupplementary MaterialsAcknowledgments

AcknowledgmentsAbout the AuthorsPART ONE: INTRODUCTIONChapter 1 Why Study Financial Markets and Institutions?PreviewWhy Study Financial Markets?Why Study Financial Institutions?Applied Managerial PerspectiveHow We Will Study Financial Markets and InstitutionsWeb ExerciseConcluding RemarksSummaryKey TermsQuestionsQuantitative ProblemsWeb Exercises

Chapter 2 Overview of the Financial SystemPreviewFunction of Financial MarketsStructure of Financial MarketsInternationalization of Financial MarketsGLOBAL: Are U.S. Capital Markets Losing Their Edge?Function of Financial Intermediaries: Indirect FinanceFOLLOWING THE FINANCIAL NEWS: Foreign Stock Market IndexesGLOBAL: The Importance of Financial Intermediaries Relative to Securities Markets: An International ComparisonTypes of Financial IntermediariesRegulation of the Financial SystemSummaryKey TermsQuestionsWeb Exercises

PART TWO: FUNDAMENTALS OF FINANCIAL MARKETSChapter 3 What Do Interest Rates Mean and What Is Their Role in Valuation?PreviewMeasuring Interest RatesGLOBAL: Negative T-Bill Rates? It Can HappenThe Distinction Between Real and Nominal Interest RatesThe Distinction Between Interest Rates and ReturnsMINI-CASE: With TIPS, Real Interest Rates Have Become Observable in the United StatesMINI-CASE: Helping Investors Select Desired Interest-Rate RiskTHE PRACTICING MANAGER: Calculating Duration to Measure Interest-Rate RiskSummaryKey TermsQuestionsQuantitative ProblemsWeb Exercises

Chapter 4 Why Do Interest Rates Change?PreviewDeterminants of Asset DemandSupply and Demand in the Bond MarketChanges in Equilibrium Interest RatesCASE: Changes in the Interest Rate Due to Expected Inflation: The Fisher EffectCASE: Changes in the Interest Rate Due to a Business Cycle ExpansionCASE: Explaining Low Japanese Interest RatesCASE: Reading the Wall Street Journal "Credit Markets" ColumnFOLLOWING THE FINANCIAL NEWS: The "Credit Markets" ColumnTHE PRACTICING MANAGER: Profiting from Interest-Rate ForecastsFOLLOWING THE FINANCIAL NEWS: Forecasting Interest RatesSummaryKey TermsQuestionsQuantitative ProblemsWeb ExercisesWeb Appendices

Chapter 5 How Do Risk and Term Structure Affect Interest Rates?PreviewRisk Structure of Interest RatesCASE: The Subprime Collapse and the Baa-Treasury SpreadCASE: Effects of the Bush Tax Cut and Its Possible Repeal on Bond Interest RatesTerm Structure of Interest RatesFOLLOWING THE FINANCIAL NEWS: Yield CurvesMINI-CASE: The Yield Curve as a Forecasting Tool for Inflation and the Business CycleCASE: Interpreting Yield Curves, 19802010THE PRACTICING MANAGER: Using the Term Structure to Forecast Interest RatesSummaryKey TermsQuestionsQuantitative ProblemsWeb Exercises

Chapter 6 Are Financial Markets Efficient?PreviewThe Efficient Market HypothesisEvidence on the Efficient Market HypothesisMINI-CASE: An Exception That Proves the Rule: Ivan BoeskyCASE: Should Foreign Exchange Rates Follow a Random Walk?Overview of the Evidence on the Efficient Market HypothesisTHE PRACTICING MANAGER: Practical Guide to Investing in the Stock MarketMINI-CASE: Should You Hire an Ape as Your Investment Adviser?CASE: What Do the Black Monday Crash of 1987 and the Tech Crash of 2000 Tell Us About the Efficient Market Hypothesis?Behavioral FinanceSummaryKey TermsQuestionsQuantitative ProblemsWeb Exercises

PART THREE: FUNDAMENTALS OF FINANCIAL INSTITUTIONSChapter 7 Why Do Financial Institutions Exist?PreviewBasic Facts About Financial Structure Throughout the WorldTransaction CostsAsymmetric Information: Adverse Selection and Moral HazardThe Lemons Problem: How Adverse Selection Influences Financial StructureMINI-CASE: The Enron ImplosionHow Moral Hazard Affects the Choice Between Debt and Equity ContractsHow Moral Hazard Influences Financial Structure in Debt MarketsCASE: Financial Development and Economic GrowthMINI-CASE: Should We Kill All the Lawyers?CASE: Is China a Counter-Example to the Importance of Financial Development?Conflicts of InterestMINI-CASE: The Demise of Arthur AndersenMINI-CASE: Credit Rating Agencies and the 20072009 Financial CrisisMINI-CASE: Has Sarbanes-Oxley Led to a Decline in U.S. Capital Markets?SummaryKey TermsQuestionsQuantitative ProblemsWeb Exercises

Chapter 8 Why Do Financial Crises Occur and Why Are They So Damaging to the Economy?PreviewAsymmetric Information and Financial CrisesDynamics of Financial Crises in Advanced EconomiesCASE: The Mother of All Financial Crises: The Great DepressionCASE: The 20072009 Financial CrisisINSIDE THE FED: Was the Fed to Blame for the Housing Price Bubble?GLOBAL: Ireland and the 20072009 Financial CrisisDynamics of Financial Crises in Emerging Market EconomiesCASE: Financial Crises in Mexico, 19941995; East Asia, 19971998; and Argentina, 20012002GLOBAL: The Perversion of the Financial Liberalization/Globalization Process: Chaebols and the South Korean CrisisSummaryKey TermsQuestionsWeb ExercisesWeb References

PART FOUR: CENTRAL BANKING AND THE CONDUCT OF MONETARY POLICYChapter 9 Central Banks and the Federal Reserve SystemPreviewOrigins of the Federal Reserve SystemINSIDE THE FED: The Political Genius of the Founders of the Federal Reserve SystemStructure of the Federal Reserve SystemINSIDE THE FED: The Special Role of the Federal Reserve Bank of New YorkINSIDE THE FED: The Role of the Research StaffINSIDE THE FED: Green, Blue, Teal, and Beige: What Do These Colors Mean at the Fed?INSIDE THE FED: How Bernanke's Style Differs from Greenspan'sHow Independent Is the Fed?Structure and Independence of the European Central BankStructure and Independence of Other Foreign Central BanksExplaining Central Bank BehaviorShould the Fed Be Independent?INSIDE THE FED: The Evolution of the Fed's Communication StrategySummaryKey TermsQuestions and ProblemsWeb Exercises

Chapter 10 Conduct of Monetary Policy: Tools, Goals, Strategy, and TacticsPreviewThe Federal Reserve's Balance SheetThe Market for Reserves and the Federal Funds RateINSIDE THE FED: Why Does the Fed Need to Pay Interest on Reserves?CASE: How the Federal Reserve's Operating Procedures Limit Fluctuations in the Federal Funds RateTools of Monetary PolicyDiscount PolicyReserve RequirementsINSIDE THE FED: Federal Reserve Lender-of-Last-Resort Facilities During the 20072009 Financial CrisisMonetary Policy Tools of the European Central BankThe Price Stability Goal and the Nominal AnchorOther Goals of Monetary PolicyShould Price Stability Be the Primary Goal of Monetary Policy?Inflation TargetingGLOBAL: The European Central Bank's Monetary Policy StrategyDisadvantages of Inflation TargetingINSIDE THE FED: Chairman Bernanke and Inflation TargetingCentral Banks' Response to Asset-Price Bubbles: Lessons from the 20072009 Financial CrisisTactics: Choosing the Policy InstrumentTHE PRACTICING MANAGER: Using a Fed WatcherSummaryKey TermsQuestionsQuantitative ProblemsWeb ExercisesWeb Appendices

PART FIVE: FINANCIAL MARKETSChapter 11 The Money MarketsPreviewThe Money Markets DefinedThe Purpose of the Money MarketsWho Participates in the Money Markets?Money Market InstrumentsCASE: Discounting the Price of Treasury Securities to Pay the InterestMINI-CASE: Treasury Bill Auctions Go HaywireGLOBAL: Ironic Birth of the Eurodollar MarketComparing Money Market SecuritiesLiquidityFOLLOWING THE FINANCIAL NEWS: Money Market RatesSummaryKey TermsQuestionsQuantitative ProblemsWeb Exercises

Chapter 12 The Bond MarketPreviewPurpose of the Capital MarketCapital Market ParticipantsCapital Market TradingTypes of BondsTreasury Notes and BondsCASE: The 20072009 Financial Crisis and the Bailout of Fannie Mae and Freddie MacMunicipal BondsCorporate BondsFinancial Guarantees for BondsCurrent Yield CalculationFinding the Value of Coupon BondsInvesting in BondsSummaryKey TermsQuestionsQuantitative ProblemsWeb Exercises

Chapter 13 The Stock MarketPreviewInvesting in StocksComputing the Price of Common StockHow the Market Sets Security PricesErrors in ValuationCASE: The 20072009 Financial Crisis and the Stock MarketCASE: The September 11 Terrorist Attack, the Enron Scandal, and the Stock MarketStock Market IndexesMINI-CASE: History of the Dow Jones Industrial AverageBuying Foreign StocksRegulation of the Stock MarketSummaryKey TermsQuestionsQuantitative ProblemsWeb Exercises

Chapter 14 The Mortgage MarketsPreviewWhat Are Mortgages?Characteristics of the Residential MortgageCASE: The Discount Point DecisionTypes of Mortgage LoansMortgage-Lending InstitutionsLoan ServicingE-FINANCE: Borrowers Shop the Web for MortgagesSecondary Mortgage MarketSecuritization of MortgagesSummaryKey TermsQuestionsQuantitative ProblemsWeb Exercises

Chapter 15 The Foreign Exchange MarketPreviewForeign Exchange MarketFOLLOWING THE FINANCIAL NEWS: Foreign Exchange RatesExchange Rates in the Long RunExchange Rates in the Short Run: A Supply and Demand AnalysisExplaining Changes in Exchange RatesCASE: Changes in the Equilibrium Exchange Rate: An ExampleCASE: Why Are Exchange Rates So Volatile?CASE: The Dollar and Interest RatesCASE: The Subprime Crisis and the DollarCASE: Reading the Wall Street Journal: The "Currency Trading" ColumnFOLLOWING THE FINANCIAL NEWS: The "Currency Trading" ColumnTHE PRACTICING MANAGER: Profiting from Foreign Exchange ForecastsSummaryKey TermsQuestionsQuantitative ProblemsWeb Exercises

Chapter 15 Appendix: The Interest Parity ConditionComparing Expected Returns on Domestic and Foreign AssetsInterest Parity Condition

Chapter 16 The International Financial SystemPreviewIntervention in the Foreign Exchange MarketINSIDE THE FED: A Day at the Federal Reserve Bank of New York's Foreign Exchange DeskBalance of PaymentsGLOBAL: Why the Large U.S. Current Account Deficit Worries EconomistsExchange Rate Regimes in the International Financial SystemGLOBAL: The Euro's Challenge to the DollarGLOBAL: Argentina's Currency BoardGLOBAL: DollarizationCASE: The Foreign Exchange Crisis of September 1992THE PRACTICING MANAGER: Profiting from a Foreign Exchange CrisisCASE: Recent Foreign Exchange Crises in Emerging Market Countries: Mexico 1994, East Asia 1997, Brazil 1999, and Argentina 2002CASE: How Did China Accumulate Over $2 Trillion of International Reserves?Capital ControlsThe Role of the IMFSummaryKey TermsQuestionsQuantitative ProblemsWeb ExercisesWeb Appendices

PART SIX: THE FINANCIAL INSTITUTIONS INDUSTRYChapter 17 Banking and the Management of Financial InstitutionsPreviewThe Bank Balance SheetBasic BankingGeneral Principles of Bank ManagementTHE PRACTICING MANAGER: Strategies for Managing Bank CapitalCASE: How a Capital Crunch Caused a Credit Crunch in 2008Off-Balance-Sheet ActivitiesCONFLICTS OF INTEREST: Barings, Daiwa, Sumitomo, and Societ Generale: Rogue Traders and the PrincipalAgent ProblemMeasuring Bank PerformanceSummaryKey TermsQuestionsQuantitative ProblemsWeb Exercises

Chapter 18 Financial RegulationPreviewAsymmetric Information and Financial RegulationGLOBAL: The Spread of Government Deposit Insurance Throughout the World: Is This a Good Thing?GLOBAL: Whither the Basel Accord?MINI-CASE: Mark-to-Market Accounting and the 20072009 Financial CrisisMINI-CASE: The 20072009 Financial Crisis and Consumer Protection RegulationE-FINANCE: Electronic Banking: New Challenges for Bank RegulationGLOBAL: International Financial RegulationThe 1980s Savings and Loan and Banking CrisisFederal Deposit Insurance Corporation Improvement Act of 1991Banking Crises Throughout the World in Recent YearsThe Dodd-Frank Bill and Future RegulationSummaryKey TermsQuestionsQuantitative ProblemsWeb ExercisesWeb Appendices

Chapter 19 Banking Industry: Structure and CompetitionPreviewHistorical Development of the Banking SystemFinancial Innovation and the Growth of the Shadow Banking SystemE-FINANCE: Will "Clicks" Dominate "Bricks" in the Banking Industry?E-FINANCE: Why Are Scandinavians So Far Ahead of Americans in Using Electronic Payments and Online Banking?E-FINANCE: Are We Headed for a Cashless Society?MINI-CASE: Bruce Bent and the Money Market Mutual Fund Panic of 2008THE PRACTICING MANAGER: Profiting from a New Financial Product: A Case Study of Treasury StripsStructure of the U.S. Commercial Banking IndustryBank Consolidation and Nationwide BankingE-FINANCE: Information Technology and Bank ConsolidationSeparation of the Banking and Other Financial Service IndustriesMINI-CASE: The 2007-2009 Financial Crisis and the Demise of Large, Free-Standing Investment BanksThrift Industry: Regulation and StructureInternational BankingSummaryKey TermsQuestionsWeb Exercises

Chapter 20 The Mutual Fund IndustryPreviewThe Growth of Mutual FundsMutual Fund StructureCASE: Calculating a Mutual Fund's Net Asset ValueInvestment Objective ClassesFee Structure of Investment FundsRegulation of Mutual FundsHedge FundsMINI-CASE: The Long Term Capital DebacleConflicts of Interest in the Mutual Fund IndustryCONFLICTS OF INTEREST: Many Mutual Funds Are Caught Ignoring Ethical StandardsCONFLICTS OF INTEREST: SEC Survey Reports Mutual Fund Abuses WidespreadSummaryKey TermsQuestionsQuantitative ProblemsWeb Exercises

Chapter 21 Insurance Companies and Pension FundsPreviewInsurance CompaniesFundamentals of InsuranceMINI-CASE: Insurance Agent: The Customer's AllyGrowth and Organization of Insurance CompaniesTypes of InsuranceCONFLICTS OF INTEREST: Insurance Behemoth Charged with Conflicts of Interest ViolationsTHE PRACTICING MANAGER: Insurance ManagementCONFLICTS OF INTEREST: The AIG BlowupPensionsCONFLICTS OF INTEREST: The Subprime Financial Crisis and the Monoline InsurersTypes of PensionsMINI-CASE: Power to the PensionsRegulation of Pension PlansThe Future of Pension FundsSummaryKey TermsQuestionsQuantitative ProblemsWeb Exercises

Chapter 22 Investment Banks, Security Brokers and Dealers, and Venture Capital FirmsPreviewInvestment BanksFOLLOWING THE FINANCIAL NEWS: New Securities IssuesSecurities Brokers and DealersMINI-CASE: Example of Using the Limit-Order BookRegulation of Securities FirmsRelationship Between Securities Firms and Commercial BanksPrivate Equity InvestmentPrivate Equity BuyoutsE-FINANCE: Venture Capitalists Lose Focus with Internet CompaniesSummaryKey TermsQuestionsQuantitative ProblemsWeb Exercises

PART SEVEN: THE MANAGEMENT OF FINANCIAL INSTITUTIONSChapter 23 Risk Management in Financial InstitutionsPreviewManaging Credit RiskManaging Interest-Rate RiskTHE PRACTICING MANAGER: Strategies for Managing Interest-Rate RiskSummaryKey TermsQuestionsQuantitative ProblemsWeb Exercises

Chapter 24 Hedging with Financial DerivativesPreviewHedgingForward MarketsTHE PRACTICING MANAGER: Hedging Interest-Rate Risk with Forward ContractsFinancial Futures MarketsFOLLOWING THE FINANCIAL NEWS: Financial FuturesTHE PRACTICING MANAGER: Hedging with Financial FuturesMINI-CASE: The Hunt Brothers and the Silver CrashTHE PRACTICING MANAGER: Hedging Foreign Exchange Risk with Forward and Futures ContractsHedging Foreign Exchange Risk with Forward ContractsHedging Foreign Exchange Risk with Futures ContractsStock Index FuturesMINI-CASE: Program Trading and Portfolio Insurance: Were They to Blame for the Stock Market Crash of 1987?FOLLOWING THE FINANCIAL NEWS: Stock Index FuturesTHE PRACTICING MANAGER: Hedging with Stock Index FuturesOptionsTHE PRACTICING MANAGER: Hedging with Futures OptionsInterest-Rate SwapsTHE PRACTICING MANAGER: Hedging with Interest-Rate SwapsCredit DerivativesCASE: Lessons from the Subprime Financial Crisis: When Are Financial Derivatives Likely to Be a Worldwide Time Bomb?SummaryKey TermsQuestionsQuantitative ProblemsWeb ExercisesWeb Appendices

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IndexABCDEFGHIJKLMNOPQRSTUVWYZ

Contents on the Web

PART SEVEN: THE MANAGEMENT OF FINANCIAL INSTITUTIONS