8 th Edition
Solution Manual
Financial Markets And Institutions 8th Edition
Anthony Saunders
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Part 1: INTRODUCTION AND OVERVIEW OF FINANCIAL MARKETS
Chapter 1: Introduction
Chapter 2: Determinants of Interest Rates
Chapter 3: Interest Rates and Security Valuation
Chapter 4: The Federal Reserve System, Monetary Policy, and InterestRates
Part 2: SECURITIES MARKETS
Chapter 5: Money Markets
Chapter 6: Bond Markets
Chapter 7: Mortgage Markets
Chapter 8: Stock Markets
Chapter 9: Foreign Exchange Markets
Chapter 10: Derivative Securities Markets
Part 3: COMMERCIAL BANKS
Chapter 11: Commercial Banks
Chapter 12: Commercial Banks’ Financial Statements and Analysis
Chapter 13: Regulation of Commercial Banks
Part 4: OTHER FINANCIAL INSTITUTIONS
Chapter 14: Other Lending Institutions
Chapter 15: Insurance Companies
Chapter 16: Securities Firms and Investment Banks
Chapter 17: Investment Companies
Chapter 18: Pension Funds
Chapter 19: Fintech Companies
Part 5: RISK MANAGEMENT IN FINANCIAL INSTITUTIONS
Chapter 20: Types of Risks Incurred by Financial Institutions
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Chapter 21: Managing Credit Risk on the Balance Sheet
Chapter 22: Managing Liquidity Risk on the Balance Sheet
Chapter 23: Managing Interest Rate Risk and Insolvency Risk on theBalance Sheet
Chapter 24: Managing Risk off the Balance Sheet with DerivativeSecurities
Chapter 25: Managing Risk off the Balance Sheet with Loan Sales andSecuritization
Part I
Introduction and Overview of Financial Markets
Chapter One
Introduction
I. Chapter Outline
1. Why Study Financial Markets and Institutions? Chapter Overview
2. Overview of Financial Markets
a. Primary Markets versus Secondary Markets
b. Money Markets versus Capital Markets
c. Foreign Exchange Markets
d. Derivative Security Markets
e. Financial Market Regulation
3. Overview of Financial Institutions
a. Unique Economic Functions Performed by Financial Institutions
b. Additional Benefits FIs Provide to Suppliers of Funds
c. Economic Functions FIs Provide to the Financial System as a Whole
d. Risks Incurred by Financial Institutions
e. Regulation of Financial Institutions
f. Trends in the United States
4. Globalization of Financial Markets and Institutions
Appendix 1A: The Financial Crisis: The Failure of Financial Institutions‘ Specialness
(available through McGraw Hill‘s Connect. Contact your McGraw Hill representative for
more information on making the appendix available to your students).
II. Learning Goals
1. Differentiate between primary and secondary markets.
2. Differentiate between money and capital markets.
3. Understand what foreign exchange markets are.
4. Understand what derivative securities markets are.
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5. Distinguish between the different types of financial institutions.
6. Know the services financial institutions perform.
7. Know the risks financial institutions face.
8. Appreciate why financial institutions are regulated.
9. Recognize that financial markets are becoming increasingly global.
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III. Chapter in Perspective
This chapter has three major sections and one minor section. The text provides a
general overview of the major types of U.S. financial markets, focusing primarily on
terminology and descriptions of the major securities, market structures and regulators.
Market microstructure is not discussed. Foreign exchange transactions are also briefly
introduced. Second, the chapter describes the various types of financial institutions and
explains the risks they face and the services they provide to funds‘ users and funds‘
suppliers. The financial crisis is discussed and the impact of Brexit is considered. The final
section of the chapter provides statistics about the rapid growth of globalization of both
markets and institutions. An appendix covering the details of the financial crisis and the
government intervention programs, including the costs as of late 2009, is available
through McGraw Hill‘s Connect. Contact your McGraw Hill representative for more
information on making the appendix available to your students.
IV. Key Concepts and Definitions to Communicate to Students
Financial markets Primary markets
Initial public offerings (IPO) Secondary markets
Derivative security Liquidity
Money markets Over-the-counter (OTC) markets
Capital markets Derivative security markets
Financial institutions Direct transfer
Price risk Indirect transfer
Delegated monitor Asset transformers
Diversify Economies of scale
Enterprise risk management (ERM)
Appendix terms include:
TARP Federal Reserve Rescue Efforts
Federal Stimulus programs American International Group
FDIC Bank takeovers Other financial initiatives
Other housing initiatives
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V. Teaching Notes
a. Why Study Financial Markets and Institutions?
For an economy to achieve its potential growth rate, mechanisms must exist to
effectively allocate capital (a scarce resource) to the best possible uses while accounting
for the riskiness of the opportunities available. Markets and institutions have been created
to facilitate transfers of funds from economic agents with surplus funds to economic agents
in need of funds. For an economy to maximize its growth potential it must create methods
that attract savers‘ excess funds and then put those funds to the best uses possible,
otherwise idle cash is not used as productively as possible. The funds transfer should occur
at as low a cost as possible to ensure maximum economic growth. Two competing
alternative methods exist: direct and indirect financing. In direct financing the ultimate
funds supplier purchases a claim from the funds demander with or without the help of an
intermediary such as an underwriter. In this case, society relies on primary markets to
initially price the issue and then secondary markets to update the prices and provide
liquidity. Trustees are appointed to monitor contractual obligations of issuers and
instigate enforcement actions for breach of contract terms. In indirect financing, the funds
demander obtains financing from a financial intermediary. The intermediary and the
borrower negotiate the terms and cost. The intermediary obtains funds by offering
different claims to fund suppliers. In this case the intermediary is usually responsible for
monitoring the contractual conditions of the financing agreement and perhaps updating
the cost if appropriate.
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The financial crisis of 2008-2009 reversed a long-term trend of deregulating
financial institutions. Regulatory risk and costs of regulation increased as a result of the
new laws, higher capital requirements and stricter regulatory oversight. A former Federal
Reserve Chair, Alan Greenspan, believed in only minimal regulation and his philosophy
appeared to prevail at many regulatory agencies including the SEC. As discussion leader,
you may wish to point out that it is not clear whether the existing rules would have been
sufficient to prevent the crisis if they had been enforced. Laws and regulations by
themselves are insufficient to ensure proper behavior in any case. Practitioners and
academics also need to emphasize business ethics and individual accountability.
Nevertheless, the financial crisis led to the massive Dodd-Frank bill (Wall Street Reform
and Consumer Protection Act) designed to limit systemic risk and tighten controls on the
institutions that many blame for causing the financial crisis. The ―Volcker Rule‖ prohibited
insured intermediaries from engaging in proprietary trading, owning, or managing a
hedge fund and private equity investments. The Volcker rule was only slowly implemented
because banks correctly maintain that many of their proprietary activities are actually
hedges to reduce risk and these are allowed. It is difficult to separate hedging from
speculative based trades. An unintended consequence of the Volcker rule is the reduction
of liquidity in the bond markets as banks reduce their bond trading activities.
Although details are not clear at this time, it is likely the Trump administration will roll
back many Dodd-Frank requirements, including the Volcker rule and the Consumer Finance
Protection Bureau‘s (CFPB) attempts to increase the fiduciary responsibility of investment
advisors with respect to conflicts of interest with their clients. In 2018, the Volker Rule was
amended to exempt smaller banks from the full scope of the Volcker Rule as well as
eliminated the presumption that positions held for fewer than 60 days violated the rule
unless bankers proved otherwise. The amendments went into effect in 2019 resulting in
bank holdings of derivative securities increasing to $201.32 trillion by 2019.
Maintaining profitability with restricted activities in a continuously evolving,
globally competitive market has been a major challenge to the financial industry. The
pace of innovation of new technology, financial products and services has not abated.
Technological advances may change traditional methods of offering financial services at
the wholesale, and perhaps eventually, at the retail level. Job opportunities for finance
students in markets and institutions are likely to continue to improve over the next ten to
twenty years as managing risks at intermediaries in increasingly complex and competitive
businesses will grow in importance. For career information you may wish to refer students
to https://dhigroupinc.com/home/default.aspx. The text provides an introductory
examination of the functions and characteristics of markets and risk and profitability
management at major financial institutions in order to help students understand the
workings of the financial system in today‘s global economy.
Growth began to pick up in 2016 and market optimism increased with the election
of the new president. The unemployment rate has fallen very low and while economic
growth has not progressed as rapidly as expected. Bond market issuance continued at a
strong pace, although overall credit provided by banks experienced a delayed growth.
This implies that larger firms have had little difficulty in obtaining credit, but some smaller
firms that rely more on bank lending continue to have difficulty obtaining credit.
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China‘s growth experienced a 6.2 percent drop in 2019 due to a prolonged trade war
with
the U.S., the lowest level in thirty years.
The United Kingdom‘s (UK) surprise vote to leave the European Union single
market in June 2016 reduced the value of the pound and global stock markets. This is not
surprising as markets dislike uncertainty. In March 2017, UK Prime Minister Theresa May
invoked ―Article 50‖ which started the 2-year process of extricating the UK from the EU.
The reason for the British exit (Brexit) vote was to reduce the amount of immigration from
EU countries. Two weeks before the October 31, 2019 deadline, the UK was still unable
to reach a deal with the EU on how the exit would be structured. The EU grants more or
less equal access to trade and capital flows among member countries, but EU rules
require allowing free immigration. In the U.S. and UK there was a backlash in 2016
against globalization and immigration. While globalization has added greatly to
economic efficiency, including improved corporate profits and lower costs of consumer
goods and services, it has also led to increased competition for jobs and kept wages from
rising. Poor real median per capita income growth has other causes as well though, such
as low productivity growth, low real interest rates and economic uncertainty. Electorates
want their governments to come up with policies that allow job protection and income
growth. This is no easy task and it may require tradeoffs between cost of consumer goods
and protecting jobs.
The most recent shock to the world‘s financial markets was the Coronavirus
Pandemic in 2020, resulting in a virtual shutdown of the world economies. The shutdown
resulted in a 32.5% drop in the DJIA in just over a month, from an all-time high of
29,388.58 on February 6, 2020 down to 19,830.01 by March 19, 2020.
As economic and competition in the markets change, attention to profits and risk
become increasingly important. Making investment and financial decisions requires
managers and individual investors with an understanding of the flow of funds throughout
the economy as well as the operations and structure of both domestic and international
markets. Financial institutions (FIs) play an important role in the functioning of financial
markets. In particular, FIs often provide the least costly and most efficient way of
channeling funds to and from financial markets.
b. Overview of Financial Markets
a. Primary Markets vs Secondary Markets
b. Money Markets vs Capital Markets
The two alternative mechanisms of fund raising are direct financing, where the
saver directly purchases a claim from the ultimate funds user in the primary market, or
indirect financing where savers place their money in a FI and the FI lends money to the
ultimate borrower. In the cases where savers desire to place their money directly in the
markets, institutions such as investment bankers (asset brokers) have evolved to assist in this
process. The first time a firm issues securities to the public is referred to as its initial public
offering (IPO). Issuing additional stock of a firm that already has stock publicly traded is
referred to as a seasoned offering (or sometimes called a ‗follow on‘ offering). In some
cases, firms offer the issue to one or only a few institutional buyers. The primary markets
are the markets where firms (and other borrowers) create and sell new securities in order
to raise cash to fund positive NPV projects (or to meet some other social goals in the case
of nonprofit fund raisers). The financial crisis drastically reduced primary market
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issues of all types. Bond issuance recovered first followed by the recovery of the IPO
issuance in 2012 and 2013.
The instructor should emphasize that the secondary markets exist to provide
liquidity and price information to investors. These functions make the primary market more
attractive. Investors would be far less likely to invest in risky long-term primary securities
unless they believe they can obtain updates of the current value of their claims and have
the ability to sell these claims quickly at low cost. Hence the efficiency of operations of
the secondary markets affects the growth rate in the overall economy through their effect
on the primary markets. Secondary market trading volume has risen dramatically in the
last several decades, particularly with the creation of wholesale and retail electronic
trading mechanisms that have substantially reduced trading costs.
Mergers can emphasize the economies of scale in the exchange business. The NYSE
merged with Euronext in 2006 and was acquired by the Intercontinental Exchange (ICE)
in 2013, after a failed merger attempt by the Deutsche-Bourse. The CME and the CBOT
have also merged. Ask students to think about the pros and cons of having only one
owner of the largest U.S. stock market versus having foreign ownership of our largest
market. Note that electronic trading is growing so rapidly that existing market structures
such as an exchange floor are having a difficult time maintaining profitability.
Money markets evolved to meet the short term investment needs (1 year or less)
of corporations and institutions desiring to earn a small positive rate of return on cash that
would be needed shortly, hence they have evolved with high denomination safe securities
that have little risk of principle loss. Capital markets are markets where borrowers raise
cash for long term investment needs. These are generally riskier than money markets and
hence, capital market securities must promise to pay a higher rate of return to attract
funds. Savers willing to take the associated risk are attracted to these markets.
Discussion question for students:
You may wish to ask students the following question that illustrates these price
changes. Suppose you start with a $1,000 investment in stocks. You lose 54% of your
investment and then you gain 71%. How much money do you end up with and what was
your net rate of return?
Answer:
Step 1: $1,000 × (1 - 0.54) =
$460 Step 2: $460 × 1.71 =
$786.60
Step 3: Your net rate of return was ($786.60 - $1,000) / $1,000 = -21.34%
c. Foreign Exchange Markets
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The majority of the world‘s business involves international business transactions.
It is increasingly important for firms to recognize that the best investment opportunity may
be located in continental Europe, the lowest cost source of funds may be found in Britain
instead of the U.S., or the highest potential sales growth rate may be in Asia. As
corporations and institutions have increased their international transactions, foreign
exchange risk has become a major source of risk for many firms today and much hedging
with spot and forward foreign exchange trades occurs.
Historically, when a nation‘s current account deficit surpasses 5% of GDP a
correction occurs in currency value. Before the financial crisis the U.S. was able to
consistently run current account deficits above 5% because foreigners were willing to
supply funds to U.S. markets. Part of the reason for this is the usage of the U.S. dollar as a
global reserve currency. Currency manipulation by foreign central banks also contributed
to the strength of the dollar. For instance, foreign central banks continue to purchase
dollars to keep local currencies down to foster their export sectors. The U.S. economy and
the dollar remain key generators of global growth and these factors help the dollar
maintain its value in the global market. The strength in the dollar since the Great Recession
has reduced profitability of some well-known U.S. multinationals with significant overseas
revenues such as IBM. Coca Cola‘s global sales exposes the company to nearly 70
different foreign currencies, exposing the company to flat or decreasing net quarter sales
in countries with currencies weak compared to the strong
U.S. dollar. Nevertheless, the excess supply of dollars available in the global economy
could precipitate a drop in the currency. The dollar‘s drop can generate long term
inflation concerns and lead to higher commodity prices because most commodities are
priced in dollars regardless of where they are traded globally.
d. Derivative Security Markets
A derivative security is a contract which derives its value from some underlying
asset or market condition. In general, the main purpose of the derivatives markets is to
transfer risk between market participants. Some participants, called hedgers, enter
derivatives contracts to reduce their risk exposure in the underlying cash market. Other
participants, called speculators, use derivative contracts to bet on price movements.
Derivatives are highly leveraged instruments. Le allows hedgers to reduce risk and
speculators to attempt to earn high rates of return with low capital investments. The two
main types of derivatives markets are the market for exchange traded derivatives and
the over the counter (OTC) derivatives markets. Exchange traded derivatives are
generally liquid and involve no counterparty risk, whereas OTC contracts are custom
contracts negotiated between two counterparties and have default risk.
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