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Financial Markets, Banking, and Monetary Monetary Policy (Wiley fi nance series)
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Financial
Markets,
Banking, and
Monetary Monetary Policy
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Financial
Markets,
Banking, and
Monetary Monetary Policy
THOMAS D. SIMPSON
Cover image: © iStockphoto.com/LeeYiuTung
Cover design: Wiley
Copyright © 2014 by Thomas D. Simpson. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
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Library of Congress Cataloging-in-Publication Data:
Simpson, Thomas D., 1942-
Financial markets, banking, and monetary policy / Thomas D. Simpson.
pages cm. — (Wiley fi nance series)
Includes index.
ISBN 978-1-118-87223-9 (hardback); ISBN 978-1-118-872468 (ePDF); ISBN 978-1-118-87205-5 (ePub)
1. Capital market. 2. Banks and banking. 3. Monetary policy. 4. Finance. I. Title.
HG4523.S568 2014
332—dc23
2014012264
Printed in the United States of America.
10 9 8 7 6 5 4 3 2 1
To my partner in life, best friend, and wife—Cindy.
vii
Preface xvii
CHAPTER 1
Introduction 1
What You Will Learn in This Chapter 1
Overview 1
Where We Are Going in This Book 2
Contributions Made by the Financial System 4
Transfers of Resources from Surplus to Defi cit Units 4
Other Contributions 8
Recurring Themes in the Chapters Ahead 11
Resources 12
CHAPTER 2
Overview of the Financial System 17
What You Will Learn in This Chapter 17
Introduction 17
Features of an Effective Financial System 17
Direct Methods of Finance 18
Investment Banks 19
Debt versus Equity 20
Money versus Capital Markets 21
Asymmetric Information 21
Adverse Selection 21
Moral Hazard 22
Indirect Methods of Finance 22
Primary versus Secondary Markets 27
Primary-Market Transactions 27
Secondary-Market Transactions 28
Trading Platforms 29
Brokers 29
CHAPTER 3
The Special Role of Commercial Banks 33
What You Will Learn in This Chapter 33
Background 33
Commercial Bank Balance Sheet 34
Assets 35
Liabilities 35
Net Worth (Capital) 36
Contents
viii CONTENTS
Payment System and Money 36
Commercial Banks and the Payment System 36
Payment System Infrastructure 40
Credit and Stored Value Cards 40
Payments Media in the Money Stock 41
Velocity (Turnover of Money) 42
Liquidity Provision 44
Dealing with Asymmetric Information 46
Maturity Transformation 46
The Safety Net and Regulatory Policy 47
CHAPTER 4
The Pricing of Financial Assets 55
What You Will Learn in This Chapter 55
Background 55
Present Value 56
Value of a Single Future Payment 57
Value of a Coupon Security 58
Other Applications 59
Solving for Yield to Maturity 59
Solving for Fixed Payments 60
The Special Case of a Consol 61
Maturity and Price Sensitivity 61
Holding Periods versus Maturities 63
Return versus Yield 63
Duration 64
Nominal versus Real Yields 66
Appendix A: Variations of the Valuation Relationship 69
Appendix B: Solutions Using a Financial Calculator 70
Future Value 70
Future Value—A Higher Interest Rate 70
Present Value of Single Cash Flow 71
Lottery Choice 71
Current Price of a Coupon Security 71
Price of an Aasset Providing Uneven
Cash Flows 71
Yield to Maturity 72
CHAPTER 5
Factors Affecting Yields 75
What You Will Learn in This Chapter 75
Background 75
The Term Structure of Interest Rates 76
The Expectations Hypothesis 77
The Term Premium Hypothesis 81
Market Segmentation Hypothesis 83
Implicit Forward Rates 84
The Role of the Term Structure 85
Contents ix
Credit Risk 85
Credit Rating Agencies 86
Investment-Grade versus Below-Investment-Grade Debt 87
Cyclical Behavior of Credit Risk and Spreads 88
Credit Default Swaps (CDSs) 89
Changing Investor Tolerance for Risk 90
Liquidity 90
Taxation 91
Embedded Options 91
Flights to Safety 92
CHAPTER 6
Principles of Portfolio Selection and Effi cient Markets 97
What You Will Learn in This Chapter 97
Overview 97
Uncertainty, Expected Return, and Risk 98
Selecting a Portfolio 99
Expected Return 99
Risk 99
Interpreting the Expression for Risk 100
An Illustration 101
These Principles in Practice 102
Effi cient Portfolios and Risk-Return Trade-Offs 103
Effi cient Markets Hypothesis 104
Implications for a Random Walk 106
Other Implications 106
Asset Bubbles 106
Evidence 107
CHAPTER 7
The Money Market 111
What You Will Learn in This Chapter 111
Background and Basic Features of the
Money Market 111
Pricing 112
Treasury Bills 114
Auction Procedures 114
The Role of Primary Dealers 114
Purpose for Issuing Bills 115
Commercial Paper 115
Credit Quality 115
Maturities 116
Asset-Backed Commercial Paper (ABCP) 116
Retreat of the ABCP Market 116
Commercial Paper Placement 117
The Role of Commercial Banks in the Money Market 117
Letters of Credit and Bankers’ Acceptances 119
Monetary Policy Effects on the Money Market 120
x CONTENTS
CHAPTER 8
The Bond Market 125
What You Will Learn in This Chapter 125
Background 125
Treasury Notes and Bonds 126
Maturities 126
Features of TIPS 127
Placement 127
When-Issued Trading 127
STRIPS 128
Secondary-Market Trading 128
Reopening 128
Purposes for Issuing Coupon Securities 129
Credit Quality 129
Corporate Bonds 129
Placements 130
Tension between Bond and Shareholders 130
Indentures and the Role of Covenants 131
Credit Default Swaps (CDSs) 132
Below-Investment-Grade Market 132
Private Placements 133
Secondary-Market Trading 133
Munis 133
Tax Considerations 134
Credit Risk and Liquidity Differences 134
General Obligation versus Revenue Bonds 134
Placement 135
Indentures 135
Ratings 135
Government-Sponsored Enterprises (GSEs) 135
Fannie Mae and Freddie Mac 136
Federal Home Loan Banks 136
Features of GSE Bonds 136
The Impact of Monetary Policy on the Bond Market 136
CHAPTER 9
Securitization 143
What You Will Learn in This Chapter 143
Background 143
Obstacles to Overcome 144
Asymmetric Information and Adverse Selection 144
Corrective Measures 145
Regulatory Capital on Ordinary Loans 145
Beginnings of Securitization—MBSs 146
Ginnie Mae 146
Illustration of the Process 146
Fannie Mae and Freddie Mac 147
Secondary-Market Trading 148
Other Mortgage Pools 148
Contents xi
Other Securitized Loans—Consumer ABSs 148
Auto ABSs 148
Credit Card ABSs 149
Other Consumer ABSs 149
Common Features 149
The Effects of the Financial Crisis 150
ABSs Involving Business Credit—CDOs and
Structured Securities 150
Standard Types of Pools—CLOs, CBOs,
and CMBSs 150
Structured Securities 150
CMOs 151
Senior-Subordinated Securities 152
Effects of the Financial Crisis 152
Securitization and the Integration of Credit Markets 152
Monetary Policy and Securitization 152
CHAPTER 10
The Mortgage Market 155
What You Will Learn in This Chapter 155
Background 155
Home Mortgages 156
Homeowner Choices 156
Standard Features of Home Mortgages 159
Commercial Mortgages 163
The Mortgage Market and Monetary Policy 163
CHAPTER 11
The Equity Market 167
What You Will Learn in This Chapter 167
Background 167
Equities as a Source of Corporate Finance 168
Preferred versus Common Shares 168
Types of Preferred 169
Primary and Secondary Markets 169
Valuation of Individual Shares 170
Basic Model 170
Dividend Growth 170
Price-Earnings 171
Some Implications 172
Extending These Principles to the Stock Market 173
Monetary Policy and the Stock Market 178
Indexes of Stock Prices 178
CHAPTER 12
Central Banking and the Federal Reserve 183
What You Will Learn in This Chapter 183
Background 183
Origins of Central Banks 184
xii CONTENTS
Constitutional Foundations 184
The Century and a Quarter without a
Central Bank 185
Creation of the Federal Reserve 186
Early Years of the Federal Reserve 188
Reforms of the 1930s 189
Fed Independence 190
Central Bank Accountability and Transparency 191
Central Bank Responsibilities 193
Monetary Operations 196
The Demand for Reserves 196
The Supply of Reserves 196
Market Equilibrium 198
Setting the Federal Funds Rate through Open
Market Operations 198
Permanent versus Temporary Transactions 200
Payment of Interest on Excess Reserves 201
The Effect of the Financial Crisis on the
Reserves Market 201
Interaction of Policy Instruments in the
Reserves Market 202
CHAPTER 13
Monetary Policy: The Basics 211
What You Will Learn in This Chapter 211
Background 211
Effects of Monetary Policy on Output
and Prices 212
The Goal of Price Stability 212
The Dual Mandate in the United States 212
The Operational Counterparts to Maximum
Employment and Price Stability 213
Maximum Employment 213
Price Stability 214
Aggregate Demand and Aggregate Supply 215
Aggregate Supply 215
Aggregate Demand 216
Monetary Policy and Aggregate Demand 218
The Model 219
Steady Infl ation 219
Rising Infl ation 220
Falling Infl ation 220
The Important Role of Infl ation Expectations 220
Actual and Potential Output in Practice 221
Addressing Infl ation 221
Addressing a Shortfall in Output 223
Okun’s Law 224
Contents xiii
CHAPTER 14
Monetary Policy: Challenges Faced by Policymakers 231
What You Will Learn in This Chapter 231
Background 231
Other Forces Affecting Output and Infl ation 232
Lags and Other Complications 234
Need to Be Forward Looking 234
Importance of the Expected Path of Short-Term Rates 235
Forward Guidance 236
Policy Rules 237
Money Stock Rule 237
Taylor Rule 237
Expectations and Central Bank Credibility 239
Infl ation Targeting 240
The Zero-Bound Constraint and the Slow Recovery
from the Great Recession 241
CHAPTER 15
Financial Crises 247
What You Will Learn in This Chapter 247
Background 247
Classic Banking Panics 248
The Nightmare of the Great Depression 250
Gold Standard Restraints 250
The Stock Market Crash 251
Bank Runs 251
Massive Damage 252
Broader Financial Crises 252
Big Drop in Asset Values 253
Runs on Suspected Institutions 253
Fire Sales 253
The Financial Crisis 254
Background Factors 255
Proliferation of Nonstandard Mortgages 255
Growing Exposures of Key Financial Institutions 256
The Unraveling 257
Shadow Banking Stress 257
Major Credit Crunch 258
Policy Responses 258
Dodd-Frank 259
Common Threads 259
CHAPTER 16
The Foreign Exchange Market and Exchange Rate Regimes 263
What You Will Learn in This Chapter 263
Background 263
Features of the Market 264
The Relation between Spot and Forward Exchange Rates 266