The 1990s were characterized as a period in which financial markets in the United States boomed. The Dow Jones Industrial Average rose from a level of 2,800 in January 1990 to more than 11,000 by the end of the decade; this compared to a move from 100 at its inception in 1906 to 2,800 thirty-four years later. However, in the early 2000s, as a result of an economic recession and corporate scandals involving major companies such as Enron, WorldCom, and Tyco, this index fell back below 10,000. Further, several stocks trading in the NASDAQ stock market lost all gains made in the late 1990s. While security values in U.S. financial markets rose dramatically in the 1990s, financial markets in Southeast Asia, South America, and Russia plummeted. More recently, in the early 2000s Argentina’s economic and financial system collapsed and its currency fell more than 30 percent in value relative to the U.S. dollar.

Meanwhile, the financial services industry continues to undergo dramatic changes. Not only have the boundaries between traditional industry sectors, such as commercial banking and investment banking, broken down but competition is becoming increasingly global in nature as FIs from Germany, France, and other European countries enter into U.S. financial service markets, and vice versa. Many forces are contributing to this breakdown in inter-industry and inter-country barriers, including financial innovation, technology, taxation, and regulation.

As the economic and competitive environments change, attention to profit and, more than ever, risk becomes increasingly important. This book offers a unique analysis of the risks faced by investors and savers interacting through both financial institutions and financial markets, as well as strategies that can be adopted for controlling and better managing these risks. Special emphasis is also put on new areas of operations in financial markets and institutions such as asset securitization, off-balance-sheet activities, and globalization of financial services.

While maintaining a risk measurement and management framework, Financial Markets and Institutions provides a broad application of this important perspective. This book recognizes that domestic and foreign financial markets are becoming increasingly integrated and that financial intermediaries are evolving toward a single financial services industry. The analytical rigor is mathematically accessible to all levels of students, undergraduate and graduate, and is balanced by a comprehensive discussion of the unique environment within which financial markets and institutions operate. Important practical tools such as how to issue and trade financial securities and how to analyze financial statements and loan applications will arm students with skills necessary to understand and manage financial market and institution risks in this dynamic environment. While descriptive concepts, so important to financial management (financial market securities, regulation, industry trends, industry characteristics, etc.) are included in the book, ample analytical techniques are also included as practical tools to help students understand the operation of modern financial markets and institutions.

Intended Audience

Financial Markets and Institutions is aimed at the first course in financial markets and institutions at both the undergraduate and M.B.A. levels. While topics covered in this book are found in more advanced textbooks on financial markets and institutions, the explanations and illustrations are aimed at those with little or no practical or academic experience beyond the introductory level finance courses. In most chapters, the main relationships are presented by figures, graphs, and simple examples. The more complicated details and technical problems related to in-chapter discussion are provided in appendixes to the chapters located at the book’s website (www.mhhe.com/sc3e).

Organization

Since our focus is on return and risk and the sources of that return and risk in domestic and foreign financial markets and institutions, this book relates ways in which a modern financial manager, saver, and investor can expand return with a managed level of risk to achieve the best, or most favorable, return-risk outcome.

The book is divided into five major sections. Part 1 provides an introduction to the text and an overview of financial markets and institutions. Chapter 1 defines and introduces the various domestic and foreign financial markets and describes the special functions of FIs. This chapter also takes an analytical look at how financial markets and institutions benefit today’s economy. In Chapter 2, we provide an in-depth look at interest rates. We first review the concept of time value of money. We then look at factors that determine interest rate levels, as well as their past, present, and expected future movements. Chapter 3 then applies these interest rates to security valuation. In Chapter 4, we describe the Federal Reserve System and how monetary policy implemented by the Federal Reserve affects interest rates and, ultimately, the overall economy.

Part 2 of the text presents an overview of the various securities markets. We describe each securities market, its participants, the securities traded in each, the trading process, and how changes in interest rates, inflation, and foreign exchange rates impact a financial institution manager’s decisions to hedge risk. These chapters cover the money markets (Chapter 5), bond markets (Chapter 6), mortgage markets (Chapter 7), foreign exchange markets (Chapter 8), stock markets (Chapter 9), and derivative securities markets (Chapter 10).

Part 3 of the text summarizes the operations of commercial banks. Chapter 11 describes the key characteristics and recent trends in the commercial banking sector. Chapter 12 describes the financial statements of a typical commercial bank, and the ratios used to analyze those statements. This chapter also analyzes actual financial statements for representative commercial banks. Chapter 13 provides a comprehensive look at the regulations under which these financial institutions operate and, particularly, at the effect of recent changes in regulation.

Part 4 of the text provides an overview describing the key characteristics and regulatory features of the other major sectors of the U.S. financial services industry. We discuss other lending institutions (savings institutions, credit unions, and finance companies), in Chapter 14, insurance companies in Chapter 15, securities firms and investment banks in Chapter 16, mutual fund firms in Chapter 17, and pension funds in Chapter 18.

Part 5 concludes the text by examining the risks facing a modern FI and FI managers, and the various strategies for managing these risks. In Chapter 19, we preview the risk measurement and management chapters that follow with an overview of the risks facing a modern FI. We divide the chapters on risk measurement and management along two lines: measuring and managing risks on the balance sheet, and managing risks off the balance sheet. In Chapter 20, we begin the on-balance-sheet risk measurement and management section by looking at credit risk on individual loans and bonds and how these risks adversely impact an FI’s profits and value. The chapter also discusses the lending process, including loans made to households and small, medium-size, and large corporations. Chapter 21 covers liquidity risk in financial institutions. This chapter includes a detailed analysis of ways in which FIs can insulate themselves from liquidity risk, and the key role deposit insurance and other guarantee schemes play in reducing liquidity risk.
In Chapter 22, we investigate the net interest margin as a source of profitability and risk, with a focus on the effects of interest rate risk and the mismatching of asset and liability maturities on FI risk exposure. At the core of FI risk insulation is the size and adequacy of the owner’s capital stake, which is also a focus of this chapter.

The management of risk off the balance sheet is examined in Chapter 23. The chapter highlights various new markets and instruments that have emerged to allow FIs to better manage three important types of risk: interest rate risk, foreign exchange risk, and credit risk. These markets and instruments and their strategic use by FIs include forwards and futures, options, and swaps.

Finally, Chapter 24 explores ways of removing credit risk from the loan portfolio through asset sales and securitization.

New Features

• In-chapter discussions of the many ethical controversies involving financial markets and institutions (such as those involving stock market brokers and dealers, commercial banks, investment banks, and mutual funds) have been added to most chapters.
  
• Ethical Debates boxes have been added to many chapters which highlight specific news stories relating to the ethical controversies involving financial markets and institutions in the early 2000s.
  
• Discussions of the impact of the Patriot Act and the Sarbannes-Oxley Act on financial institutions management is included throughout several chapters.
  
• The impact of the economic slowdown and the subsequent economic recovery in the U.S and worldwide on financial markets and institutions is highlighted and discussed in all relevant chapters. This discussion is particularly evident in the first six chapters of the book.
  
• The impact of historically low interest rates and their eventual increase on financial institutions management is highlighted.
  
• A discussion of the controversy surrounding the federal government’s implicit backing of Fannie Mae and Freddie Mac, and the impact the increased level of risk in these two agencies posed to the U.S. economy in the early 2000s, is added to Chapter 7.
  
• The latest information pertaining to new capital adequacy rules (or Basel II), that are scheduled for implementation at the end of 2006, has been added to Chapter 13. The discussion includes detailed examples of the calculation of capital adequacy under both Basel I and II.
  
• The latest changes to deposit insurance premiums charged to financial institutions and insurance coverage for financial institution customers are discussed in Chapter 13.
  
• Tables and Figures in all chapters have been revised to include the most recently available data.
  
• Sections of the text that include a discussion of international issues and events are highlighted. These sections have been updated to contain the most recent issues pertaining to financial institutions worldwide.
  
• Appendices for Chapters 3, 5, 8, 9, 10, 13, 17, 20, and 23 are available at the book’s website at www.mhhe.com/sc3e.
  
• Search the Site problems included in the body of various chapters and among the end of chapter problems have been substantially enhanced. These problems now guide the student through the website as they collect the requested data. Further, these problems now ask the student to evaluate the data collected at the website.
  
• Excel problems have been included among the end of chapter problems. These problems ask the student to solve numerical problems similar to those seen in the text examples.

Acknowledgments

We take this opportunity to thank all of those individuals who helped us prepare this third edition. We want to express our appreciation to those instructors whose insightful comments and suggestions were invaluable to us during this revision.

Jack Aber - Boston University
Susan Banerjee - Tulane University
James Barth - Auburn University
Peter Basciano - Augusta State University
John R. Becker Blease - University of New Hampshire
Sam Bulmash - University of Southern Florida
Mitch Charkiewicz - Central Connecticut State University
Yew-Mow Chen - San Francisco State University
Erik Devos - SUNY-Binghamton
John Dominick - University of Arkansas
Michael Goldstein - Babson College
Alan E. Grunewald - Michigan State University
Gayle de Haas - Mississippi State University
John Halloran - University of Notre Dame
William C. Handorf - George Washington University
Jean Helwege - Ohio State University
Jann Culvahouse Howell - Iowa State University
Sylvia Hudgins - Old Dominion University
William Jackson - University of North Carolina, Chapel Hill
Bill Lepley - University of Wisconsin, Green Bay
Tim Manuel - University of Montana
Bill Marcum - Wake Forest University
Joe Mascia - Adelphi University
Joseph R. Mason - Drexel University
Clark Maxam - Montana State University
Joe Ogden - SUNY-Buffalo
Evren Ors - Southern Illinois University
Fred Puritz - SUNY-Oneonta
Chip Ruscher - University of Arizona
Sherrill Shaffer - University of Wyoming
Richard S. Swasey, Jr. - Northeastern University
John Thorton - Kent State University
Jim Tripp - Western Illinois University
George Vlachos - Wayne State University
Dan Walz - Trinity University
Berry Wilson - Pace University
Mei "Miranda" Zhang - Mercer University

We would also like to thank the staff at McGraw-Hill, especially Steve Patterson, Publisher; Christina Kouvelis, Development Editor II; Kristin Bradley, Project Manager; Adam Rooke, Designer; Gina Hangos, Production Supervisor; Brian Nacik, Lead Media Project Manager; and Kai Chiang, Media Producer.

Anthony Saunders
Marcia Millon Cornett