SECURITIES OPERATIONS 641

24-1 Functions of Securities Firms, 641 24-1a Facilitating Stock Offerings, 641 24-1b Facilitating Bond Offerings, 643 24-1c Securitizing Mortgages, 645 24-1d Advising Corporations, 645 24-1e Financing for Corporations, 646 24-1f Providing Brokerage Services, 646 24-1g Operating Mutual Funds, 647 24-1h Proprietary Trading, 648 24-1i Summary of Services Provided, 648 24-1j Interaction with Other Financial Institutions, 649 24-1k Participation in Financial Markets, 650 24-1l Conflicts of Interest from Participation, 650 24-1m Expanding Functions Internationally, 651

24-2 Regulation of Securities Firms, 652 24-2a Stock Exchange Regulations, 652 24-2b Regulatory Events That Affected Securities Firms, 653

24-3 Valuation of a Securities Firm, 654 24-3a Factors That Affect Cash Flows, 655 24-3b Factors That Affect the Required Rate of Return, 655

24-4 Exposure of Securities Firms to Risk, 656 24-4a Market Risk, 656 24-4b Interest Rate Risk, 657 24-4c Credit Risk, 657 24-4d Exchange Rate Risk, 657 24-4e Impact of Financial Leverage on Exposure to Risk, 657

24-5 Impact of the Credit Crisis on Securities Firms, 658 24-5a Government Assistance to Bear Stearns, 658 24-5b Failure of Lehman Brothers, 660 24-5c Impact of the Crisis on Regulatory Reform, 661

25: INSURANCE AND PENSION FUND OPERATIONS 667

25-1 Background, 667 25-1a Determinants of Insurance Premiums, 667 25-1b Investments by Insurance Companies, 669 25-1c Regulation of Insurance Companies, 669

25-2 Life Insurance Operations, 671 25-2a Ownership, 671 25-2b Types of Life Insurance, 671 25-2c Sources of Funds, 672 25-2d Capital, 673 25-2e Uses of Funds, 673 25-2f Asset Management of Life Insurance Companies, 675 25-2g Interaction with Other Financial Institutions, 676

Contents xxiii

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25-3 Other Types of Insurance Operations, 677 25-3a Property and Casualty Insurance, 677 25-3b Health Care Insurance, 679 25-3c Business Insurance, 680 25-3d Bond Insurance, 680 25-3e Mortgage Insurance, 681

25-4 Exposure of Insurance Companies to Risk, 681 25-4a Interest Rate Risk, 682 25-4b Credit Risk, 682 25-4c Market Risk, 682 25-4d Liquidity Risk, 682 25-4e Exposure to Risk during the Credit Crisis, 682 25-4f Government Rescue of AIG, 683

25-5 Valuation of an Insurance Company, 683 25-5a Factors That Affect Cash Flows, 683 25-5b Factors That Affect the Required Rate of Return by Investors, 684 25-5c Indicators of Value and Performance, 684

25-6 Background on Pension Funds, 686 25-6a Public versus Private Pension Funds, 686 25-6b Defined-Benefit versus Defined-Contribution Plans, 686 25-6c Pension Fund Participation in Financial Markets, 688 25-6d Pension Regulations, 689

25-7 Pension Fund Management, 691 25-7a Management of Insured versus Trust Portfolios, 691 25-7b Management of Portfolio Risk, 692 25-7c Corporate Control by Pension Funds, 693

25-8 Performance of Pension Funds, 693 25-8a Pension Fund’s Stock Portfolio Performance, 693 25-8b Pension Fund’s Bond Portfolio Performance, 693 25-8c Performance Evaluation, 694 25-8d Performance of Pension Portfolio Managers, 695

Part 7 Integrative Problem: Assessing the Influence of Economic Conditions across

a Financial Conglomerate’s Units, 699

Final Self-Exam, 700

Appendix A: Comprehensive Project, 705

Appendix B: Using Excel to Conduct Analyses, 715

Glossary, 719

Index, 730

xxiv Contents

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Preface

Financial markets finance much of the expenditures by corporations, governments, and individuals. Financial institutions are the key intermediaries in financial markets because they transfer funds from savers to the individuals, firms, or government agencies that need funds. Financial Markets and Institutions, 11th Edition, describes financial markets and the financial institutions that serve those markets. It provides a conceptual frame- work that can be used to understand why markets exist. Each type of financial market is described with a focus on the securities that are traded and the participation by finan- cial institutions.

Today, many financial institutions offer all types of financial services, such as bank- ing, securities services, mutual fund services, and insurance services. Each type of finan- cial service is unique, however. Therefore, the discussion of financial services in this book is organized by type of financial service that can be offered by financial institutions.

Since the credit crisis, regulatory actions have been taken to prevent another crisis in the future. Accordingly, this text gives special attention to the impact of financial reform on each type of financial market and financial institution.

INTENDED MARKET This text is suitable for undergraduate and master’s level courses in financial markets, or financial institutions. To maximize students’ comprehension, some of the more difficult questions and problems should be assigned in addition to the special applications at the end of each chapter and the Comprehensive Project. A term paper on the credit crisis may also be a valuable exercise, and several possible topics for this paper are provided at the end of the first chapter.

ORGANIZATION OF THE TEXT Part 1 (Chapters 1 through 3) introduces the key financial markets and financial institu- tions, explains why interest rates change over time, and explains why yields vary among securities. Part 2 (Chapters 4 and 5) describes the functions of the Federal Reserve System (the Fed) and explains how its monetary policy influences interest rates and other economic conditions. Part 3 (Chapters 6 through 9) covers the major debt security markets, Part 4 (Chapters 10 through 12) describes equity securities markets, and Part 5 (Chapters 13 through 16) covers the derivative security markets. Each chapter in Parts 3 through 5 focuses on a particular market. The integration of each market with other markets is stressed throughout these chapters. Part 6 (Chapters 17 through 20) concen- trates on commercial banking, and Part 7 (Chapters 21 through 25) covers all other types of financial services provided by financial institutions.

Courses that emphasize financial markets should focus on the first five parts (Chapters 1 through 16); however, some chapters in the section on commercial banking are also relevant. Courses that emphasize financial institutions and financial services should focus on Parts 1, 2, 6, and 7, although some background on securities markets (Parts 3, 4, and 5) may be helpful.

xxv

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Professors may wish to focus on certain chapters of this book, and skip others, de- pending on the other courses available to their students. For example, if a course on de- rivative securities is commonly offered, Part 5 of this text may be ignored. Alternatively, if an investments course provides a thorough background on types of securities, Parts 3 and 4 can be given less attention.

Chapters can be rearranged without a loss in continuity. Regardless of the order in which chapters are studied, it is highly recommended that some questions and exercises from each chapter be assigned. These exercises may serve as a focal point for class discussion.

The credit crisis receives considerable emphasis in the mortgage markets chapter (Chapter 9) because it was primarily caused by activities in the mortgage market. The crisis has had an impact on every type of financial market and institution, however, so it is covered in each chapter as it applies to the contents of that chapter.

COVERAGE OF MAJOR CONCEPTS AND EVENTS Numerous concepts relating to recent events and current trends in financial markets are discussed throughout the chapters. These include the following:

■ New laws applied to bond rating agencies ■ Increased exposure of municipal bonds to default ■ Facebook’s IPO ■ Performance of venture capital and private equity funding ■ Government rescues of financial institutions during the credit crisis ■ Credit default swaps ■ Behavioral finance ■ Emergence of private stock exchanges, such as SecondMarket and SharesPost ■ Dark pools used to trade stocks ■ Recent developments in insider trading ■ New restrictions on proprietary trading by banks ■ Occupy Wall Street protests ■ Backdating of options ■ Governance in financial markets ■ The Fed’s increasing role in financial markets ■ Role of analysts ■ Value-at-risk applications ■ Asymmetric information ■ Valuation of financial institutions ■ Regulatory reform in financial services

Each chapter is self-contained, so professors can use classroom time to focus on the more complex concepts and rely on the text to cover the other concepts.

FEATURES OF THE TEXT The features of the text are as follows:

■ Part-Opening Diagram. A diagram is provided at the beginning of each part to illustrate generally how the key concepts in that part are related.

■ Objectives. A bulleted list at the beginning of each chapter identifies the key concepts in that chapter.

xxvi Preface

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■ Examples. Examples are provided to reinforce key concepts. ■ Financial Reform. A Financial Reform icon in the margin indicates a discussion of

financial reform as it applies to the topics covered in the chapter.

FINANCIAL REFORM ■ Global Aspects. A Global Aspects icon in the margin indicates international

coverage of the topic being discussed. ■ Summary. A bulleted list at the end of each chapter summarizes the key concepts.

This list corresponds to the list of objectives at the beginning of the chapter. ■ Point Counter-Point. A controversial issue is introduced along with opposing

arguments, and students are asked to determine which argument is correct and to explain why.

GLOBAL ASPECTS

■ Questions and Applications. The Questions and Applications section at the end of each chapter tests students’ understanding of the key concepts and may serve as homework assignments or study aids in preparation for exams.

■ Interpreting Financial News. At the end of each chapter, students are challenged to interpret comments made in the media about the chapter’s key concepts. This gives students practice in interpreting announcements by the financial media.

■ Managing in Financial Markets. At the end of each chapter, students are placed in the position of financial managers and must make decisions about specific situations related to the key concepts in that chapter.

■ Flow of Funds Exercise. A running exercise is provided at the end of each chapter to illustrate how a manufacturing company relies on all types of financial markets and financial services provided by financial institutions.

■ Internet/Excel Exercises. At the end of each chapter, there are exercises that introduce students to applicable information available on various websites, enable the application of Excel to related topics, or a combination of these. For example, the exercises allow students to assess yield curves, risk premiums, and stock volatility.

■ Problems. Selected chapters include problems to test students’ computational skills.

■ WSJ Exercise. This exercise appears at the end of selected chapters and gives stu- dents an opportunity to apply information provided in the Wall Street Journal to specific concepts explained in that chapter.

■ Integrative Problems. An integrative problem at the end of each part integrates the key concepts of chapters within that part.

■ Term Paper on the Credit Crisis. Several topics for term papers on the credit crisis are suggested at the end of Chapter 1.

■ Comprehensive Project. This project, found in Appendix A, requires students to apply real data to several key concepts described throughout the book.

■ Midterm and Final Self-Examinations. At the end of Chapter 16, a midterm self-exam is offered to test students’ knowledge of financial markets. At the end of Chapter 25, a final self-exam is offered to test students’ knowledge of financial institutions. An answer key is provided so that students can evaluate their answers after they take the exam.

The concepts in each chapter can be reinforced by using one or more of the features just listed. Professors’ use of the features will vary depending on the level of their students and the course focus. A course that focuses mostly on financial markets may emphasize tools such as the WSJ Exercises and Part 1 of the Comprehensive Project (on taking posi- tions in securities and derivative instruments). In contrast, a course that focuses on finan- cial institutions may assign an exercise in which students must review recent annual

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Preface xxvii

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reports (see Part 2 of the Comprehensive Project) to determine how a particular financial institution’s performance is affected by its policies, industry regulations, and economic conditions. In addition, the Internet/Excel Exercises on financial institutions give students practice in assessing the operations and performance of financial institutions.

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