Financial Markets and Institutions 8th Edition

Book Preface

The last 35 years have been dramatic for the financial services industry. In the 1990s and 2000s, boundaries between the traditional industry sectors, such as commercial banking and investment banking, broke down and competi-tion became increasingly global in nature. Many forces contributed to this breakdown in interindustry and intercountry barriers, including financial innovation, technology, taxation, and regulation. Then in 2008–2009, the financial services industry experienced the worst financial crisis since the Great Depres-sion. Even into the mid-2010s, the U.S. and world economies had not recovered from this crisis. Most recently, the financial consequences of the 2020 worldwide COVID-19 pan-demic are unknown but are likely to be larger than any event in history. It is in this context that this book is written.
As the economic and competitive environments change, attention to profit and, more than ever, risk become increasingly important. This book offers a unique analysis of the risks faced by investors and savers interacting through both financial institutions and financial mar-kets, 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, under-graduate and graduate, and is balanced by a comprehensive discussion of the unique envi-ronment 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 the skills necessary to understand and man-age 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 MBA levels. While topics covered in this book are found in more advanced textbooks on financial markets and institutions, the explana-tions 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 tech-nical problems related to in-chapter discussion are provided in appendixes to the chapters (available through McGraw-Hill Connect Finance or your course instructor).

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 finan-cial manager, saver, and investor can expand return with a managed level of risk to achieve the best, or most favorable, return–risk outcome.
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 look at factors that determine interest rate levels, as well as their past, present, and expected future movements. We then review the concept of time value of money. 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 manager’s decisions to hedge risk. These chapters cover the money markets (Chapter 5), bond markets (Chapter 6), mortgage markets (Chapter 7), stock markets (Chapter 8), for-eign exchange 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 ana-lyze 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, the effect of recent changes in regulation.
Part 4 of the text provides an overview describing the key characteristics and regula-tory 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, investment companies in Chapter 17, pension funds in Chapter 18, and fintech firms in Chapter 19.
Part 5 concludes the text by examining the risks facing a modern FI and FI manag-ers and the various strategies for managing these risks. In Chapter  20, we preview the risk measurement and management chapters in this section 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  21, 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 corpora-tions. Chapter  22 covers liquidity risk in financial institutions. This chapter includes a detailed analysis of the 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 23, 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 liabil-ity 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 24. The chapter highlights various new markets and instruments that have emerged to allow FIs to bet-ter 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, futures, options, and swaps.
Finally, Chapter  25 explores ways of removing credit risk from the loan portfolio through asset sales and securitization.