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 PREFACE

he last 30 years have been dramatic for the financial services industry. In the

T
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 have not recovered from this
crisis. 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,
vii
viii Preface

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, and pension funds in Chapter 18.
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 19, 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 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 corpora-
tions. Chapter 21 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 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 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 23. 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 24 explores ways of removing credit risk from the loan portfolio
through asset sales and securitization.

NEW FEATURES
· Tables and figures in all chapters have been revised to include the most recently avail-
able data.
· Revised “After the Crisis” boxes highlighting significant events related to the financial
crisis have been added to chapters throughout the book.
· Updates on the major changes proposed for the regulation of financial institutions are
included where appropriate throughout the book.
· Discussion of how financial markets and institutions continue to recover from the
financial crisis has been added throughout the book. Virtually every chapter includes
 Preface ix

new material detailing how the financial crisis affected risk management in financial
institutions.
· Several chapters include a discussion of Brexit as its affects the risk and return for
investors in financial markets and financial institutions.
· Several chapters include a discussion of the impact of initial interest rate increases by
the Federal Reserve.
· Several chapters include a discussion of the impact of China’s economic policies and
economic slowdown on financial markets.
· Chapter 1 includes a new section on enterprise risk management. The chapter also pro-
vides an update on the implementation of the Wall Street Reform and Consumer Protec-
tion Act enacted as a result of the financial crisis.
· Chapter 4 provides an update on the Federal Reserve’s actions intended to strengthen
the U.S. economy, including the interest rate increases instituted by the Fed.
· Chapter 5 includes updates on the LIBOR scandal.
· Chapter 6 discusses China’s and worldwide Treasury holdings and the potential impact
of these holdings on the U.S. economy.
· Chapter 8 includes more on dark pools and Brexit’s impact on worldwide stock markets.
· Excel spreadsheets containing bank financial statements and ratio calculations have
been added to Chapter 12.
· Chapter 13 includes a discussion of how the Volcker Rule and Consumer Protection
Regulation have affected the operations of financial institutions.
· Chapter 14 includes a discussion of new payday lending legislation
· Chapter 17 includes more on new regulations for money market mutual funds.
· Chapter 21 includes updates of the new international liquidity standards enacted as a
result of the financial crisis.

ACKNOWLEDGMENTS
We take this opportunity to thank all of those individuals who helped us prepare this and
previous editions. We want to express our appreciation to those instructors whose insight-
ful comments and suggestions were invaluable to us during this revision.
Keldon Bauer Ozde Oztekin
Tarleton State University Florida International University–Miami
Jen-Chi Cheng O. John Paskelian
Wichita State University University of Houston Downtown
Kathy English Blaise Roncagli
Wilmington University Cleveland State University
Andrew Fodor Matthew Ross
Ohio University–Athens Western Michigan University–Kalamazoo
Robert Goldberg Benjamin Thompson
Adelphi University Lincoln Memorial University
Walt Nelson Ann Marie Whyte
Missouri State University University of Central Florida–Orlando
Abdullah Noman David Zalewski
Nicholls State University Providence College
We would like to thank the staff at McGraw-Hill for their help and guidance, especially
Chuck Synovec, executive brand manager; Noelle Bathurst, senior product developer;
Heather Ervolino, content project manager; Tobi Philips, digital product developer; Trina
Maurer, senior marketing manager; and Dave O’Donnell, marketing specialist. Additional
thanks to Alex Marden for his editorial assistance.

Anthony Saunders

Marcia Millon Cornett

 Introduction and Overview of Financial Markets part one
Confirming Pages

WALKTHROUGH

The Federal Reserve

Introduction and Overview of Financial Markets c h one
part apter

4
Chapter Features
System, Monetary
Policy,
The andFederal Interest
Reserve chapter

4
Confirming Pages

Rates
System, Monetary
The following special features have been
O U T L I N E
integrated throughout the text to encourage
student interaction and to aid students in
Policy, and Interest
absorbing and retaining the material Major Duties and
Responsibilities of the Federal

Rates
Reserve System: Chapter
96
CHAPTER-OPENING OUTLINESPart 1 Introduction and Overview of Financial MarketsOverview
O U T L I N E

These outlines offer students a snapshot view of Structure

Major Duties andof the Federal
Federal
what they can expect to learn from each Reserve Banks operate as nonprofit Responsibilities
chapter’s organizations. They generate income pri-
of the Federal
Reserve System
marily from three sources: (1) interest earned on government securities acquired in the
Lear ndiscussion.
ing Goals Reserve System: Chapter
course of Federal Reserve open market transactions Organization of the
Overview(see below), (2) interest earned on
reserves that banks are required to deposit at the Fed
Structure
Federal
(see Reserve System
reserve
of the Federalrequirements below), and
LG 4-1 Understand the major functions of(3)
the Federal Reserve System.
fees from the provision of payment and other services to member
Board
Reserve System depository
of Governors of the institutions.
Learning Goals FederalofReserve
Organization the System
LG 4-2 Identify the structure of the Federal Board of Governors
Reserve System. of the Federal ReserveFederal System Reserve SystemChapter 4 The Federal Reserve System, Monetar
LG 4-1 Understand the major functions of the Federal Reserve System.
Federal Open Market
The Board of Governors of the Federal Reserve (also Boardcalled the ofFederal
of Governors
Committee the Reserve Board)
LG 4-3 Identify the monetary policy tools used by the Federal Reserve. Federal Reserve SystemFederal
LG 4-2 is a seven-member
Identify the structure of the Federal Reserve System.board headquartered in Washington, DC. Each member is appointed
Open Market Committee
Functions
Federal Performed by
Open Market
by the president of the United States and Federal
must be Open
confirmed by the Senate. Board mem-
LG 4-4 Appreciate how monetary policy
Market
Federal ReserveThe BanksFederal Open Market Committee (FO
policychangesusedaffect
thekey economic variables. Committee
LG 4-3 Identify the monetary bers
toolsserve a nonrenewable
by Federal 14-year
Reserve. term.4 Committee
Board members (FOMC) are often bodyindividuals with PhD
of the Federal Reserve System. As allude
degrees in economics and/or an extensive The background Balance
Functions Sheetbyofmembers
Performed
in economic
major monetary
the
research and
of thepolitical
Federal Reserve Board of Gov
LG 4-5 Understand
LG 4-4 how central banks around the world adjusted their monetary Federal Reserve Banks Bank of New York, and the presidents of four
Appreciate how monetary service, particularly in the area of banking.
policy changes affect key economic variables. Board members’
policy-making body of theterms are staggered so that
Federal Reserve
policy during the recent financial crisis.one term expires every other January. TheFederal president Balance Sheet of two
designates
Reserve System. basis). Theof
the members chair
theofboard
the Board of Governors is
LG 4-5 Understand how central banks around the world adjusted their monetary Monetary Policy Tools
required to meet at least four times each year in
to be the chair and vice chair for four-year terms. TheFederal
board Reserve
usually meets several times per
policy during the recent financial crisis. MonetaryOpen
Policy Market scheduled meetings have been held each year s
Tools Operations
week. As they carry out their duties, members routinely confer with officials of other
The main gov-
responsibilities of the FOMC
ernment agencies, representatives of banking industry The
Opengroups,Discount
Market Rate
officials
Operations
employment, economicofgrowth, price stability
of central banks
other countries, members of Congress, and academics. The Discount
ReserveRate trade. The FOMC seeks to accomplish this b
Requirements
MAJOR DUTIES LEARNING
AND RESPONSIBILITIES
GOALSAND RESPONSIBILITIES
OF
The primary THE FEDERAL
responsibilities of the Federal openReserve
market Board
Reserve are
Requirements
(Reserve theoperations.
Ratios) formulation Open andmarket
con- operations—the pu
MAJOR DUTIES duct of monetary OFpolicy
THE FEDERAL
and the supervision operations
and regulation of
(Reserve Ratios)banks. eral seven
All agencyboard
securities—is
mem- the main policy tool
RESERVE SYSTEM: CHAPTER OVERVIEW The Federal Reserve, getsthe Money
(although the operations themselves are no
RESERVE
Learning SYSTEM:
goals CHAPTER
(LGs) appear at the OVERVIEW
bers beginning of
sit on the Federal Open Market Committee, Purchases which
and makes
sales of key
The Federal Reserve, the Money decisions affecting the
Central banks determine, implement, and control the monetary policy in their home Supply,
U.S. government andandfed-
Interest Reserve Bank of New York, as discussed below
Rates
each chapter to provide a quick availability
introduction of money
to
Central banks determine, implement, and control the monetary policy in their home and credit in the economy (see below).
Supply, and For
Interest example,
Rates the Federal Reserve
countries. The Federal Reserve (the Fed) isFed)
theBoard,
central bank ofthethe United States. Founded eral agency securities by of the monetary aggregates, sets the federal fu
countries.
the The
key chapter Federal Reserve
material. (the
These through
is the central
goals are bank
also ofFOMC,
the Unitedcan and usually
States. Founded does set Reserve.
money
the FederalEffects
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of Monetary and
of Monetary
Tools interest
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of the Federal Reserve in foreign exchange ma
by Congressintegrated
under
by the Federal
Congress under the
with theReserve
Federal Act in Act
Reserve
end-of-chapter 1913,
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inFederal
1913,
questions the
Reserve original
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original duties
also were
were
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bank pro- requirements
reserve on Various
on Various (discussed
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reserve requirements13) and
and the discount rate are n
videwith
the nation with a safer, more flexible, and more
vide the nation and a safer,
problems, more
which flexible,
allows and reviews
more
instructors to stable
stable
and monetary
monetary
approves
easily theandandfinancial
financial
discount ratessystem.
system.
(see below) set by
Variablesthe 12 Federal
Variables are Reserve
monitoredBanks.and guided by the FOMC. Assoc
This was needed following a number of banking crises and panicsthat
This was needed emphasize following a number
theoflearning of banking
goal(s) as they crises
The and
Federal
choose. Reservethat
1 panics
had occurred
had
Board occurred inin
also has primary Money responsibility
Money Supplyfor
Supply versus release the supervision
versus and The Beige Book su
of the Beige Book.
the first decade the 20th century (particularly 1907)
1 and the last decades of the 19th Targeting conditions by Federal Reserve district. Inform
the first decade of the 20th century (particularly 1907)
regulation ofand
(1) the
all last
bank
century. As time passed, additional legislation, including the Banking Act of 1935, the Full decades
holding of the
companies 19th (their nonbank
Interest Rate subsidiaries
Interest Rate Targeting and their foreign
subsidiaries), (2) state-chartered BOLD banksKEY that are
TERMS members
AND of
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Federal
MARGINAL Reserve from
GLOSSARY bank directors, interviews w
System
century. As time passed,Act
Employment additional
of 1946, legislation,
and the Full including
Employmentthe andBanking
BalancedAct of 1935,
Growth Act ofthe Full
1978 International Monetary Policies
andInternational Monetary experts,
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Employment(also Actcalled
of 1946, and the Full Employment
the Humphrey-Hawkins Act),(state-chartered
revised and memberGrowth
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and supplemented banks),
the TheAct
original and (3)1978
of
purposes
main Edge Act
terms and and agreement
Strategies
concepts arecorporations
emphasized (through
5 and Strategies economic meetings in the world. As the FOMC
and objectives of the Federal Reserve which
System.
(also called the Humphrey-Hawkins Act), revised and supplemented the original U.S.
These banks
objectives conduct
included foreign
economic operations).
throughout growth
purposes The
the chapter Fed also
Systemwide shares
Rescue
byEmployed
bold key supervisory
icy,terms and
called
its actions regu-
affect out
not only the U.S. economy
latory responsibilities with state and other federal Programs
supervisors
Systemwide (e.g.,
Rescuethe OCC, the FDIC),
and objectives of the Federal Reserve System. These objectives included economic
www.occ.treas.gov
in the text growth
and defined in the margins
including overseeing both the operations of foreignduring
1. The Panic of 1907 was a financial crisis that hit the United States at the turn of the 20th century while the country
the Financial Crisis
banking
Programsorganizations
EmployedFunctions in the United by Federal Rese
Performed
StatesStockand the index
establishment,
fell by 50 percentexamination, Challenges
in less than a year, and termination Remain after
was in the midst of an economic recession. The New York Exchange duringofthebranches,
Financial commercial lend-
Crisis
As part of the Federal Reserve System, Federal R
and a severe drop in market liquidity by banks resulted in numerous bank runs; bank, corporate, and municipal bank- the Crisis
1. The Panic of 1907 was a financial crisis that hit the United States
www.fdic.gov ing subsidiaries,
ruptcies; and a near collapse of the U.S. financial system.
at the turn of theand20th representative
PERTINENT
century while offices WEB
the country of foreign
ADDRESSESbanks in the United
tions.
States. The
These include assistance in the conduct of
was in the midst of an economic recession. The New York Stock Exchange index fell by 50 percent in less thanand
a year, Challenges Remain after
board approves member bank Website
mergers acquisitions
addresses are and specifies permissible
ofinmember banks nonbank
and other large financial institu
and a severe drop in market liquidity by banks resulted in numerous bank runs; bank, corporate, and municipal bank- thereferenced
Crisis 93for the margins
activities of bank holding companies. The board is also responsible the
of services development
such as new currency issue, check cl
ruptcies; and a near collapse of the U.S. financial system. throughout each chapter, providing additional
and administration of regulations governing the fair provision of consumer the federalcredit (e.g., themember banks, or the g
government,
resources to aid in the learning process.
Truth in Lending Act, the Equal Credit Opportunity Act). Finally, the Wall93
in Table Street
4–1. TheReform
In the News box in this section
and Consumer Protection Act of 2010 provided unprecedented powers extraordinary
to theservices
Federalin many of these areas in
Reserve, putting it in charge of monitoring any of the country’s biggest financial firms—
x
those considered critical to the health of the financial system as a whole. TABLE 4–1 Functions Performed by the Fed
sau19714_ch04_093-131.indd 93 07/07/17 03:10 PM
The chair of the Federal Reserve Board, currently Janet Yellen, often advises the pres-
ident of the United States on economic policy and serves as the spokesperson Assistance forin the
theconduct
Fed- of monetary policy—
Federal Open Market Committee (FOMC). FRB
eral Reserve System in Congress and to the public. All board members share the duties of
Supervision and regulation—FRBs have supervi
 would remain at these levels for an “extended period.” It was not until the spring and sum-
Assets.
mer of 2013 that the The major
Fed mentioned the endassets onlow
of these theinterest
Federal Reserve’s
rates balance sheet
and the tightening of are Treasury and gov-
ernment agency (i.e., Fannie Mae, Freddie Mac) securities,
monetary policy. And even then, the Fed repeatedly stated that the end of its monetary eas- Treasury currency, and gold
andcome
ing actions would not foreign
untilexchange.
the very slowWhile interbank
economic growthloans
picked(loans to domestic
up. It was not until banks) are quite a small
December 2015 that the Fedofeventually
portion the Federalraised interest rates
Reserve’s (forthey
assets, the first
playtime
an in 10 years).role in implementing mon-
important
etary policy (see below).
Open Market Operations
www.newyorkfed.org Treasury
As mentioned earlier, operations Treasury
Securities.
open market securities
are the Federal (54.2
Reserves’s percentorofsales
purchases total assets in 2016) are the
of securities in thelargest asset on
U.S. Treasury the Fed’s
securities balance
market. Whensheet. Theymonetary
a targeted represent the Fed’s holdings of securities
aggregate
Federal Reserve issued
or interest rate level by the U.S.
is determined Treasury
by the FOMC,(U.S. government).
it is forwarded to the The Fed’s
Federal open market operations involve
Reserve
Board Trading Desk Board Trading Desk the atbuying
the Federal
and Reserve
selling Bank of New
of these York (FRBNY)
securities. through(decrease)
An increase a state- in Treasury securities
Pedagogical Features
Unit of the Federal Reserve ment called the policy
helddirective. Theleads
by the Fed manager
to anofincrease
the Trading Desk uses
(decrease) inthe
thepolicy
money direc-
supply.
Bank of New York through tive to instruct traders on the daily amount of open market purchases or sales to transact.
which open market opera- These transactions take place on an over-the-counter market in which traders are linked to
tions are conducted.
U.S. Government Agency Securities. U.S. government agency securities are the
each other electronically (see Chapter 5).
To determine second-largest
a day’s activity asset
for openaccount
marketon the Fed’sthebalance
operations, staff at sheet (39.2 percent of total assets in
the FRBNY
policy directive 2016). However, in 2007 this account was 0.0
begins each day with a review of developments in the fed funds market since the previous percent of total assets. This account grew
Statement sent to the Fed- day and a determination of the as the Fed
actual took steps
amount to improve
of reserves in the credit
banking market
system
“DO YOU UNDERSTAND” liquidity
the previ- and BOXES
support the mortgage
eral Reserve Board Trading ous day.
D O YO U U N D E R S TA N D :The staff also and
reviews housing
forecasts markets
of short-term duringfactorsthe financial
that may crisis
affect by
the buying
supply mortgage-backed secu-
Desk from the FOMC that and demand of reserves on rities that day. With this information, These
the staff boxes
decides allow
theMac,students
level of Ginnie to test
(MBS) backed by Fannie Mae, Freddie and Mae. Under the
specifies the daily amount
1. What the main transactions
functionsneeded
of to obtain the desired fed program,
funds rate.the TheFOMCthemselves
processcalled on thewith
is completed main a concepts
of open market purchases MBS purchase for the purchase of up to $1.25 trillion
daily conference
Federal Reserve Banks are? call to the Monetary Affairs Division at the Board presented within and
of Governors each onemajor chapter
or sales to transact. of agency MBS. The purchase activity began on January 5, 2009, and continued
2. What the main of the four voting Reserve Bank presidents (outside of New York)
responsibilities section. Solutions
to discuss are provided in Connect.
the FRBNY
plans for theBoard
through 2016. Thus, the Fed expanded its role as purchaser/guarantor of assets in
day’s open market operations. Once a plan is approved, the Trading Desk is
of the Federal Reserve
are? instructed to execute the day’s thetransactions.
financial markets.
3. How the FOMC Open market operations are particularly important because“IN
implements theyTHE NEWS”
are the primaryBOXES
deter-
minant
monetary policy? of changes in bank Gold
excess and
reservesForeign
in the Exchange
banking system andand Treasury
thus directly
These boxes demonstrate Currency.
impact Theapplication
the Federal Reserve
the size of the money supply
4. What the main assets and
holds Treasury
and/or the levelgold certificates
of interest rates that
(e.g., are
the fedredeemable
funds rate). at the
of chapter material to real current events. U.S. Treasury for
When the Federal
liabilities of the Federal Reserve
Reserve purchases
gold. The securities,
Fed also it pays
holds for the
small securities
amounts byof either writing
Treasury-issued coinage and foreign-
are? a check on itself or directly denominated
transferring funds (by wire
assets transfer)
to assist into the seller’s
in foreign currency account.
transactions or currency swap
Either way, the Fed credits the reserve deposit account of the bank that sells it (the Fed) the
agreements with the central banks of other nations.
IN-CHAPTER EXAMPLES IN THE NEWS
securities. This transaction increases the bank’s excess reserve levels. When the Fed sells
These examples provide securities,numerical
it either collects checks received as payment or receives wire transfers of funds
from these Interbank
agents material
(such as banks) Loans. As mentioned
using funds from their accounts earlier,atdepository
the Federal institutions
Reserve in need of additional
demonstrations of the analytical funds can borrow at the Federal The Financial
Reserve’s discount Crisis:
window Toward an
(discussed Explanation
in detail below). and P
Banks to purchase securities. This reduces the balance of the reserve account of a bank that
described in manypurchases chapters. TheThus,
interest
whenratetheor discount
securities. Federal therate
InReserve charged
first sells on as
these
half of(purchases)
2007, loans isinoften
thesecurities
extent the lower
off the than other
company’s interest
balance sheet. That 2
rates in(increases)
open market, it decreases the short-term money account)
banks’ (reserve markets deposits
(see Chapter
at the Fed.
of declining home prices became 5). As we discuss below, in January month, the board also announced s
2003 the Fed implemented changes
apparent, banks to and
its discount
other financial windowConfirminglending
the creation policy
Pages that
of the Termincreased
Securities s
the cost of discount window marketborrowingparticipantsbut startedeased to reas-the requirements Lending on which
Facility depository
(TSLF), swapping lo
EXAMPLE 4–1institutions Purchases can ofborrow. As
Securitiessesspart byof
the the
value this ofchange,
Federal
mortgages theand
Reserve discount window Treasuryrate was increased
securities on its balanceso a
that it would be higher than the fed fundssecurities
mortgage-backed rate. Asthat a result, (discount)
sheet for less interbank loanssecurities
liquid private are B
Suppose the FOMC instructs the FRBNY Trading Desk to purchase $500 million of Trea-
normally a relatively small they portion
owned, of the Fed’s
especially those total in assets. held in the private sector, and the
the e
sury securities. Traders at the FRBNY call primary government securities dealers of major
commercial and investment banks (such as Goldman subprimeSachs segment andofMorgan
the housing Stanley),9 who Primary Dealer Credit Facility (PDCF). c
provide a list of securities they have available market. for sale,The autumnthe
including of 2007 saw
denomination, matu- These actions, particularly the latter, in
rity, and the price on each security. FRBNY traders increasing seekstrains in a number
to purchase the target of number represented
of a significant expansion F
A F T E R Tsecurities H E (atCthe R desired
I S I Smaturities and lowestmarket possible segments, including
price) until theyasset- have purchased of
“AFTER THE CRISIS” the federal financial safety net by F
the $500 million. The FRBNY then notifies its backedgovernmentcommercial bondpaper, department
and banks BOXESto receive making available a greater amount of T
Goldman and Reaches
pay the sellers$5 for Billion
the securities it has purchased.
Settlement also over beganThe tosecurities
exhibit adealer
Mortgage-Backed reluctance sellers to (such as
Securities
central bank credit, at prices unavail- to
These boxes use articles
lend to one another for terms much able in the market, to institutions (the D
In January 2016, Goldman Sachs residential mortgages, longer and whether ofThis
a complex pertaining
mortgage-linked to eventsdeal.
sau19714_ch04_093-131.indd 104
than overnight. reluctance primary dealers) beyond those banks
07/07/17 03:10 PM th
agreed to pay more 9. Asthan $52016,
of June billion, thewere 23 banks
there primarydeceived investors
securities dealers wasbyreflected
trading, misrepre-
on average,in$0.82 In February
trillion
a dramatic of rise incaused
securities2015,
theper day. or
Morganthataffected
Stanley
typically borrowby the at the discount R
largest regulatory penalty in its history. senting the quality of underlying
London Interbank loans. Offered reached 2008–2009
Ratea (LIBOR)
preliminary accord
window. financial
. . .the crisis
with fi
In settling with the Justice Department The government’s inquiry into Goldman
at most maturities greater Justicethan to elaborate
Department
over- in which In on chapter
the fall
the firmof 2008, financial mar- $
and a collection of other state and related to mortgage-backed night. securities
LIBOR is a measure agreed of tothepaymaterial.
$2.6 billion.
rates ketsThat month, experienced another
worldwide
Chapter 4 The Federal Reserve System, Monetary Policy, and
federal entities, Goldman resolved the firm packaged andatsold which between
internationalGoldman banks make said in a regulatoryround filing that
of heightened volatility and his- to
claims stemming from the Wall Street 2005 and 2007, whendollar the housing loans to one another. it had been Sinceinformed bytoric U.S.changes:
officials Lehman Brothers filed tw
firm’s sale of mortgage bonds heading market was booming INTERNATIONAL
and
thatinvestor
initial disruption, MONETARY
infinancial
December markets2014POLICIES
thatforit might
Chapter AND STRATEGIES
face11a bankruptcy protec- le
into the financial crisis. It joined a list demand for related bonds have was strong. in a state
remained civil lawsuit
Central
of high stemming
banks guide
vola- from
tion; thethegovern-
investmentmonetary policy
banking in virtually al
companies in
sau19714_ch04_093-131.indd 108 07/07/17 03:10 PM
of other big banks in moving past one The latest settlement is just
tility, withone many interest ment’s mortgage-bond
European
rate spreadsCentralGoldman probe.
Bank In May, isand
(ECB)
Sachs theMorgan
central Stanley
bank for the Eo
INTERNATIONAL COVERAGE
of the biggest, and most costly, legal of several that Goldman at has paid in high levels.
historically the firm said it wasisinthe
of England talks with U.S.
central
successfully banksubmitted
of the United Kingdom. Like
applications lo
An international
problems of theiconcrisis appears in the margin
era. The govern- relation to the crisis. Goldman agreed and independent
state authorities central
to banks
resolve thosewhose decisions do not need toto
In response to this turbulence, to become bank holding companies;
to easily
ment communicate where international
had earlier won multibillion-dollar to pay $1.2 billion in penalties In Incontrast, the People’s Bank of China, the Reserve Bank
the Fed to and thethe federal claims.govern- the settlement, BankGoldman
of America purchased Merrill s
material is being
settlements fromintroduced.
J.P. Morgan Federal Housing Finance Agency in agreed of Brazil are less independent in that the government impo
ment have taken a series of to pay to the Justice
dramatic Lynch;Depart-Wells Fargo acquired Wachovia; re
Chase, Bank of America, and Citi- 2014 to settle claims that it failed to camement the
aclose,operations
$2.385 billionofcivil
these central banks. Independence of a ce
monetary
steps. As 2007 to athe the
bank is must
PNC
free from
Financial Services Group
pressure from politicians who mayd
pur-
group. Crisis-related settlements by disclose the risks on mortgage
Federal Reserve bonds Board penalty.
announced Goldman also provide
chased National City Corporation; andat the1e
banks, mortgage firms, brokerages and it sold. In 2010, the firmthe agreed to of a Term$1.8 activity
billionFacil-in in the shortrelief
consumer termthrough
(e.g., around election time)
creation Auction
growth. Therefore, the American
independent International
central banks
xi operate withm
others total at least $181.1 billion. pay $550 million to settle a Securi-
ity (TAF), in which fixed debt forgiveness
amounts of to borrowers,
Group the
received significant financial
The investigations examined ties and Exchange Commission Regardless of their independence, in the increasinglyp
term funds are auctioned construction
to deposi- and financing of afford-
around the worldassistance
must workfrom the Federal
not only to guideReserve
the monetaryO
how Wall Street sold bonds tied to complaint stemming from its handling
tory institutions against any able housing,
collateral and otherand programs.
tries, but also to coordinate the Treasury Department.
their efforts with thoseOn of other wc
eligible for discount window look loans.
at how central thebanks
policyaroundfront, thetheFederal Reserve
world took independen ti
 make a down payment of 20 percent of the purchase price. Option 1: M
(LG 7-4) Option 2: M
a. Calculate your monthly payments on this mortgage. Which optio
b. Construct the amortization schedule for the first six b. Your bank
payments. payment:
WALKTHROUGH 6. Using a Spreadsheet to Calculate Mortgage Option 1: M
Option 2: M
Payments: What is the monthly payment on
a $150,000, 15-year mortgage if the mortgage rate is Which optio
11. You plan to pur
5.75 percent? 6.25 percent? 7.5 percent? 9 percent? (LG 7-4)
mortgage obtai
Present Interest
Confirming Pages The Payment down payment
Periods ⇒
End-of-Chapter Features Value Rate Will Be not pay off the m
$150,000 15 × 12 5.75%/12 $1,245.62 a. Your bank
150,000 15 × 12 6.25%/12 1,286.13 payment:
150,000 15 × 12 7.50%/12 1,390.52 Option 1: M
150,000 15 × 12 9.00%/12 1,521.40 Option 2: M
130 Part 1 Introduction and Overview of Financial Markets
Which optio
b. Your bank
SUMMARY
EXCEL PROBLEMS 7. Using a Spreadsheet to Calculate Mortgage payments:
Excel problems are featured
This in selected
chapter described the Federal Reserve System in the Payments: WhatFederal
The
United 4States.
Chapter is the
The monthlySystem,
Reserve
Federal payment on Policy, andOption
Monetary M
Interest1:Ra
Reserve is
chapters and are denoted by an icon.the central bank charged with a $150,000,
conducting 30-year
monetary mortgage
policy, if
supervising the
and mortgage rate is Option 2: M
regulating depository institutions, maintaining thepercent?
stability6.25
of the financial system, and9 percent? (LG 7-4) Which optio
Spreadsheet templates are available in 6. MHM Bank 5.75 currently has $250percent?
million7.5in percent?
transaction What is the full effect of this pur
providing specific financial services to the U.S. government, the public, and financial
Connect. deposits on its balance sheet. The current reserve require- and the money You plan to pur
12. supply?
institutions. We reviewed the structure under which the Fed provides these functions, the
ment is 10Presentpercent, but the Federal Reserve Interest
is increasing The Payment b. What is the full mortgage
effect of this pur
obtai
monetary policy tools it uses, and the impact of monetary Periods policy changes on money sup- ⇒
Value to 12 percent. (LG 4-3) Rate
this requirement Will Be and the money supplydown ifpayment
borrower
ply, credit availability, interest rates, security prices, and foreign exchange rates.
a. Show the balance sheet of the Federal Reserve and of these funds tonot their
paybanks
off thein m
$150,000 30 × 12 5.75%/12 $ 875.36
MHM Bank if MHM Bank converts all excess reserves deposits? a. Your bank
QUESTIONS 150,000 30 × 12 6.25%/12 923.58
to loans, but borrowers return only 80 percent of these 9. Marly Bank currentlypayment: has $650
150,000 30 × 12 7.50%/12 1,048.82
1. Describe the functions performed by Federal Reserve 10.funds
Whattoare MHM Bankused
the tools as transaction
by the Federal deposits.
Reserve to imple- deposits on its balanceOptionsheet. The1: M c
b. Show
150,000
the balance sheet
30 × 12 9.00%/12 1,206.93
Banks. (LG 4-1) ment monetary policy? (LG of4-3)the Federal Reserve and ment is 10 percent, butOption the Federal
2: M
2. Define the discount rate and the discount window. (LG 4-2) 11.MHM
Explain Bank
how ifa decrease
MHM Bank in theconverts
discount 85 rate percent of its
affects credit this requirement to 9 percent. (LG 4-
excess reserves
availability and to
theloans
moneyand borrowers
supply. (LG 4-3) return 90 percent Which optio
3. Describe the structure of the Board of Governors of the a. Show the balance sheet of the
You toplan toBankpurchase a $200,000 house using either b. Your bank
Federal Reserve System. (LG 4-2) 12.ofWhy
these8.funds
does MHM
the Federal Reserve as transaction
END-OF-CHAPTER
rarely deposits.
use the discount rateQUESTIONS
to Marlya Bank if Marly Bank conv
implement 30-year mortgage
its instructed
monetary policy? obtained
(LG from Desk your local savings tobank payments:
4. What are the primary responsibilities of the Federal Reserve 7. The FOMC has AND
the FRBNY PROBLEMS
4-3) Trading to loans, but borrowers return on
Board? (LG 4-1) purchase $500 with a
million rate
in of
U.S.7.25 percent,
Treasury
13. What changes did the Fed implement to its discount or a
securities.15-year
The mortgage
Fed- with a rate
funds to National Option
Bank 1: M
as transac
of
has6.50
window lending
eral Reserve percent.
policy
currently
The
in You
setthe
questions
will2000s?
theearly
reserve make and the problems
a down
in
requirement latepayment
at
inb.20
of the end-
per-
Show the balance Option
sheet of2:the M
5. What are the primary responsibilities of the Federal Open
Market Committee? (LG 4-2) 5 2000s?
percent of (LGcent of
transaction
4-3) the of-chapter
purchase
deposits. price.
Assume material
(LG
U.S. 7-3)
banks appear
with- in separate
Marly Bank if Which
Marly Bankoptioco
6. What are the major liabilities of the Federal Reserve draw ofa.the
all excess
14. Which Calculate
reserves sections,
the
and give
monetary toolsamount
out loans.
availableallowing
of(LG
tointerest
the instructors
4-3)Federal to choose
and, separately, prin-
its excess reserves
13. Youtoplan loansto an
pu
System? Describe each. (LG 4-2) Reservealso
a. Assume is most
that often
cipal used?
borrowers
paid Why?
on each
whether (LG
eventually returnprefer
mortgage.
4-3)
they allWhat
of theseis the difference
students percent
to engage in of thesemortgage
funds to obtai
Marl
15.funds to their banks inpaid?
the activities deposits.
7. Why did reserve deposits increase to the point that this Describe
eral Reserve
how interest
expansionary
impact
inform of conducted
transaction
quantitative by deposits.
or the Fed-
qualitative analysis offered to you i
account represented the largest liability account on the What is theb.full effecttheofmoney
Calculate your supply, credit
this purchase
monthly on availability,
bank
payments deposits
on the two mortgages.
Brown Bank currently
interest rates, and security of the
prices. Domaterial.
the same forSelected
contrac-
10.
problems are ment has
of 20$350
perc
Federal Reserve’s balance sheet in the late 2000s? (LG 4-2) and the moneyWhat supply? is the difference in the monthly payment on
depositstheon its balance sheet. Theyoc
tionary activities. (LG 4-4) assignable online in Connect. a. Calculate
8. What are the major assets of the Federal Reserve System? b. What is the full effect of this purchase on bank deposits ment is 10 percent,b.butConstruct
the Federa
Summarize
16.and
two
the supply
mortgages? measures taken by central
monetaryif policy th
Describe each. (LG 4-2) the money borrowers return only 95 per- this requirement to 11 percent. (LG 4
banks
cent of 9.
to
theseYou
address
fundsplan
theto to
worldwide
their purchase
financial
banks in a
the $240,000
crisis.
form (LG
of house
4-5)
transac- using either a How much t
9. Why did U.S. government agency securities go from nothing a. Show the balance sheet of the
to being the largest asset account on the Federal Reserve’s tion deposits? 30-year mortgage obtained from your local bank with Brown a Bank14. You plan
if Brown Banktoconvpu
balance sheet in the late 2000s? (LG 4-2) 8. The FOMC has rateinstructed
of 5.75 percent,
the FRBNYor a Trading
15-year Desk
mortgage
to with a rate of but borrowers
to loans, mortgage obtai
return on
purchase $750 5.00 percent.
million You will
in U.S. makesecurities.
Treasury a down payment
The of 20 percent offered
funds to Brown Bank to you i
as transacti
Federal Reserve of the
haspurchase
currentlyprice.
set the(LG 7-3) requirement
reserve b. Show the balancementsheet
of 20ofperc
the
PROBLEMS at 10 percent a. of Calculate
transaction the amount
deposits. of interest
Assume and, separately, Brown
U.S. banks prin- Bank if a.
National Bankyo
Calculate
1. Suppose the Federal Reserve instructs the Trading Desk withdraw
set theallreservecipal
excess paid and
reserves onateach
requirement give mortgage.
out loans.
10 percent of (LGWhat
4-3) is the difference
transaction in
its excess reserves to loans anth
b. Construct
to purchase $1 billion of securities. Show the result of this a. Assume
deposits.also
(LGthat
4-3)borrowers
interest paid?eventually return all of these percent of these funds
HowtomuchBrowt
transaction on the balance sheets of the Federal Reserve funds
a. If tothetheir banks
Federal in the decreases
Reserve form of transaction
the reserve deposits.
require- deposits.
System and commercial banks. (LG 4-3) ment to 6 percent, show the balance sheet of BSW and
2. Suppose the Federal Reserve instructs the Trading Desk to the Federal Reserve System just before and after the full
sell $850 million of securities. Show the result of this trans- effect of the reserve requirement change. Assume BSW
action on the balance sheets of the Federal Reserve System withdraws all excess reserves and gives out loans and
and commercial banks. (LG 4-3) that borrowers eventually return all of these funds to
BSW in the form of transaction deposits.
3. Bank Three currently has $600 million in transaction depos-
SEARCH THE SITE
its on its balance sheet. The Federal Reserve has currently SEARCH THE SITE
b. Redo part (a) using a 14 percent reserve requirement.
set theamong
reserve requirement 5. National Bank currently has $500 million in transaction
Featured the end-at 10 percent of transaction deposits on its balance
deposits. (LG 4-3) Go to the Federal Reserve Board sheet.
websiteTheand
current
findreserve require-
the latest information available on the prime rate, the dis
of-chapter
a. If thematerial in most
Federal Reserve decreases the reserve requirement ment is 10 percent, but the Federal Reserve is decreasing
the three-month T-bill rate using the following
sau19714_ch07_208-239.indd 238
this requirement to 8 percent. (LG 4-3) steps. Go to www.federalreserve.gov. Under “Select Statisti
chapters, to 8these
percent,Internet
show the balance sheet of Bank Three and
the weave
Federal Reserve click
System just before and after the full on “Selected
a. ShowInterest
the Rates.”
balance Click
sheet ofon the
the most
Federal recent
Reserve date.
and The data will be in this file on your compu
exercises the web, National Bank if National Bank converts all excess
effect of the reserve requirement change. AssumeQuestionsBank
real data, and
Three practical
withdraws all excess reserves and gives out loans reserves to loans, but borrowers return only 50 percent
of these funds to National Bank as transaction deposits.
applications with concepts
and that borrowers eventually return all of these 1. What are the
funds to current levels for each of these interest rates?
Bank Three in the form of transaction deposits. b. Show the balance sheet of the Federal Reserve and
found in the book. 2. Calculate the percentage
National Bank change in each
if National Bank of these 75
converts rates since June 2016.
percent
b. Redo part (a) using a 12 percent reserve requirement.
of its excess reserves to loans and borrowers return 60
4. BSW Bank currently has $150 million in transaction depos- percent of these funds to National Bank as transaction
its on its balance sheet. The Federal Reserve has currently deposits.
xii
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xv
CONTENTS IN BRIEF

Preface vii
part 4 OTHER FINANCIAL
INSTITUTIONS 454
part 1 INTRODUCTION AND OVERVIEW
OF FINANCIAL MARKETS 1 14. Other Lending Institutions: Savings Institutions,
Credit Unions, and Finance Companies 454
1. Introduction 1
15. Insurance Companies 480
2. Determinants of Interest Rates 26
16. Securities Firms and Investment Banks 506
3. Interest Rates and Security Valuation 58
17. Investment Companies 531
4. The Federal Reserve System, Monetary Policy,
and Interest Rates 93 18. Pension Funds 564

part 2 SECURITIES MARKETS 132 part 5 RISK MANAGEMENT IN

FINANCIAL INSTITUTIONS 585
5. Money Markets 132
19. Types of Risks Incurred by Financial
6. Bond Markets 169 Institutions 585
7. Mortgage Markets 208 20. Managing Credit Risk on the Balance Sheet 604
8. Stock Markets 240 21. Managing Liquidity Risk on the Balance
9. Foreign Exchange Markets 282 Sheet 632

10. Derivative Securities Markets 311 22. Managing Interest Rate Risk and Insolvency
Risk on the Balance Sheet 655
part 3 COMMERCIAL BANKS 353 23. Managing Risk off the Balance Sheet with
11. Commercial Banks: Industry Derivative Securities 683
Overview 353
24. Managing Risk off the Balance Sheet with Loan
12. Commercial Banks’ Financial Statements and Sales and Securitization 712
Analysis 380 References 739
13. Regulation of Commercial Banks 413 Index 741

xvi

Preface vii
part 1 INTRODUCTION AND OVERVIEW
OF FINANCIAL MARKETS 1
1 Introduction 1
Why Study Financial Markets and Institutions?
­Chapter Overview 1
Overview of Financial Markets 3
Primary Markets versus Secondary Markets
Money Markets versus Capital Markets 6
Foreign Exchange Markets 9
Derivative Security Markets 9
Financial Market Regulation 10
Overview of Financial Institutions 11
Unique Economic Functions Performed by
Financial Institutions 12
Additional Benefits FIs Provide to Suppliers of
Funds 14
Economic Functions FIs Provide
to the Financial System as a
Whole 15
Risks Incurred by Financial Institutions 16
Regulation of Financial Institutions 16
Trends in the United States 17
Globalization of Financial Markets and
Institutions 21
Appendix 1A: The Financial Crisis: The Failure
of Financial Institutions’ Specialness 25
2 Determinants of
Interest Rates 26
Interest Rate Fundamentals: Chapter
Overview 26
Loanable Funds Theory 27
Supply of Loanable Funds 28
Demand for Loanable Funds 29
Equilibrium Interest Rate 30
Factors That Cause the Supply and Demand
Curves for ­Loanable Funds to Shift 31
Movement Of Interest Rates Over Time 35
Determinants of Interest Rates for Individual
Securities 36
Inflation 36
Real Risk-Free Rates 36
Default or Credit Risk 38
Liquidity Risk 40
Special Provisions or Covenants 40
Term to Maturity 40
CONTENTS
Term Structure of Interest Rates 42
Unbiased Expectations Theory 42
Liquidity Premium Theory 44
Market Segmentation Theory 46
Forecasting Interest Rates 48
Time Value of Money and Interest Rates 49
Time Value of Money 49
Lump Sum Valuation 50
Annuity Valuation 52
4 3 Interest Rates and Security
Valuation 58
Interest Rates as a Determinant of Financial
Security Values: Chapter Overview 58
Various Interest Rate Measures 59
Coupon Rate 59
Required Rate of Return 59
Expected Rate of Return 60
Required versus Expected Rates of Return: The
Role of Efficient Markets 61
Realized Rate of Return 62
Bond Valuation 63
Bond Valuation Formula Used to Calculate Fair
Present Values 63
Bond Valuation Formula Used to Calculate
Yield to Maturity 65
Equity Valuation 66
Zero Growth in Dividends 68
Constant Growth in Dividends 69
Supernormal (or Nonconstant) Growth in
Dividends 70
Impact of Interest Rate Changes on Security
Values 71
Impact of Maturity on Security Values 72
Maturity and Security Prices 73
Maturity and Security Price Sensitivity to
Changes in Interest Rates 73
Impact of Coupon Rates on Security Values 74
Coupon Rate and Security Price 75
Coupon Rate and Security Price Sensitivity to
Changes in Interest Rates 75
Duration 76
A Simple Illustration of Duration 76
A General Formula for Duration 78
Features of Duration 82
Economic Meaning of Duration 83
Large Interest Rate Changes and Duration 85
Appendix 3A: Duration and Immunization 92
Appendix 3B: More on Convexity 92
xvii
xviii Contents

4 The Federal Reserve System, Other Financial Institutions 158

Monetary Policy, and Interest Individuals 158
Rates 93 International Aspects of Money Markets 158
Euro Money Markets 160
Major Duties and Responsibilities of the Federal
Appendix 5A: Single versus Discriminating
Reserve System: Chapter Overview 93
Price Treasury Auctions 168
Structure of the Federal Reserve System 94
Organization of the Federal Reserve System 94 Appendix 5B: Creation of a Banker’s
Board of Governors of the Federal Reserve Acceptance 168
System 96
Federal Open Market Committee 97 6 Bond Markets 169
Functions Performed by Federal Reserve
Definition of Bond Markets: Chapter
Banks 97
Balance Sheet of the Federal Reserve 102 Overview 169

Monetary Policy Tools 105 Bond Market Securities 170

Open Market Operations 108
The Discount Rate 110
Reserve Requirements (Reserve Ratios) 113
The Federal Reserve, the Money Supply, and
Interest Rates 116
Effects of Monetary Tools on Various Economic
Variables 117
Money Supply versus Interest Rate
Targeting 118
International Monetary Policies and
Strategies 123
Systemwide Rescue Programs Employed during
the Financial Crisis 123
Challenges Remain after the Crisis 128
part 2 SECURITIES MARKETS 132
5 Money Markets 132
Definition of Money Markets: Chapter
Overview 132
Money Markets 133
Yields on Money Market Securities 133
Bond Equivalent Yields 134
Effective Annual Return 134
Discount Yields 134
Single-Payment Yields 135
Money Market Securities 136
Treasury Bills 138
Federal Funds 144
Repurchase Agreements 145
Commercial Paper 148
Negotiable Certificates of Deposit 153
Banker’s Acceptances 154
Comparison of Money Market Securities 155
Money Market Participants 155
The U.S. Treasury 156
The Federal Reserve 156
Commercial Banks 156
Money Market Mutual Funds 157
Brokers and Dealers 157
Corporations 158
Treasury Notes and Bonds 170
Municipal Bonds 181
Corporate Bonds 187
Bond Ratings and Interest Rate Spreads 193
Bond Market Indexes 196
Bond Market Participants 197
Comparison of Bond Market Securities 198
International Aspects of Bond Markets 198
Eurobonds, Foreign Bonds, and Sovereign
Bonds 201
7 Mortgage Markets 208
Mortgages and Mortgage-Backed
Securities: Chapter Overview 208
Primary Mortgage Market 210
Mortgage Characteristics 211
Mortgage Amortization 216
Other Types of Mortgages 221
Secondary Mortgage Markets 223
History and Background of Secondary Mortgage
Markets 224
Mortgage Sales 225
Mortgage-Backed Securities 225
Participants in the Mortgage Markets 233
International Trends in Securitization 234
Appendix 7A: Amortization Schedules
for 30-Year Mortgage in Example 7–2 and
No-Points versus Points Mortgages in
Example 7–4 239
8 Stock Markets 240
The Stock Markets: Chapter Overview 240
Stock Market Securities 242
Common Stock 242
Preferred Stock 245
Primary and Secondary Stock Markets 247
Primary Stock Markets 247
Secondary Stock Markets 252
Stock Market Indexes 262
 Contents xix

Stock Market Participants 266

Other Issues Pertaining to Stock Markets 268
part 3 COMMERCIAL BANKS 353
Economic Indicators 268
11 Commercial Banks: Industry
Market Efficiency 269
Stock Market Regulations 272
Overview 353
International Aspects of Stock Markets 274 Commercial Banks as a Sector of the
Financial ­Institutions Industry: Chapter
Appendix 8A: The Capital Asset Pricing
Overview 353
Model 281
Definition of a Commercial Bank 355
Appendix 8B: Event Study Tests 281
Balance Sheets and Recent Trends 355
Assets 355
9 Foreign Exchange Markets 282
Liabilities 358
Foreign Exchange Markets and Risk: Chapter Equity 359
Overview 282 Off-Balance-Sheet Activities 359
Other Fee-Generating Activities 363
Background and History of Foreign Exchange
Markets 283 Size, Structure, and Composition of the
Industry 364
Foreign Exchange Rates and Transactions 288
Bank Size and Concentration 365
Foreign Exchange Rates 288
Bank Size and Activities 367
Foreign Exchange Transactions 288
Return and Risk of Foreign Exchange Industry Performance 368
Transactions 293 Regulators 371
Role of Financial Institutions in Foreign Federal Deposit Insurance Corporation 371
Exchange Transactions 299 Office of the Comptroller of the
Interaction of Interest Rates, Inflation, and Currency 372
Exchange Rates 302 Federal Reserve System 373
Purchasing Power Parity 303 State Authorities 373
Interest Rate Parity 305 Global Issues 373
Appendix 9A: Balance of Payment Advantages and Disadvantages of International
Accounts 310 Expansion 373
Global Banking Performance 375

10 Derivative Securities Markets 311

Derivative Securities: Chapter Overview 311 12 Commercial Banks’ Financial
Statements and Analysis 380
Forwards and Futures 313
Spot Markets 313 Why Evaluate the Performance of
Forward Markets 314 Commercial Banks? ­Chapter
Futures Markets 316 Overview 380
Options 323 Financial Statements of Commercial
Call Options 323 Banks 382
Put Options 325 Balance Sheet Structure 383
Option Values 327 Off-Balance-Sheet Assets and Liabilities 389
Option Markets 329 Other Fee-Generating Activities 392
Regulation of Futures and Options Income Statement 393
Markets 335 Direct Relationship between the Income
Statement and the Balance Sheet 397
Swaps 336
Interest Rate Swaps 337 Financial Statement Analysis Using a Return on
Currency Swaps 341 Equity Framework 398
Credit Swaps 342 Return on Equity and Its Components 399
Swap Markets 343 Return on Assets and Its Components 401
Other Ratios 406
Caps, Floors, and Collars 345
Impact of Market Niche and Bank Size on
International Aspects of Derivative Securities
Financial Statement Analysis 407
Markets 347
Impact of a Bank’s Market Niche 407
Appendix 10A: Black–Scholes Option Pricing Impact of Size on Financial Statement
Model 352 Analysis 407
xx Contents

13 Regulation of Size, Structure, and Composition of the

Commercial Banks 413 Industry 455
Balance Sheets and Recent Trends 457
Specialness and Regulation: Chapter Regulators 459
Overview 413 Savings Institution Recent Performance 460
Types of Regulations and the Regulators 414 Credit Unions 461
Safety and Soundness Regulation 414 Size, Structure, and Composition of the
Monetary Policy Regulation 417 Industry 462
Credit Allocation Regulation 417 Balance Sheets and Recent Trends 464
Consumer Protection Regulation 417 Regulators 466
Investor Protection Regulation 418 Industry Performance 466
Entry and Chartering Regulation 418 Finance Companies 468
Regulators 419 Size, Structure, and Composition of the
Regulation of Product and Geographic Industry 468
Expansion 419 Balance Sheets and Recent Trends 469
Product Segmentation in the U.S. Commercial Industry Performance 474
Banking Industry 419 Regulation 475
Geographic Expansion in the U.S. Commercial Global Issues 476
Banking Industry 426
Bank and Savings Institution Guarantee 15 Insurance Companies 480
Funds 427 Two Categories of Insurance Companies:
The Federal Deposit Insurance Corporation Chapter Overview 480
(FDIC) 428
The Demise of the Federal Savings and Loan Life Insurance Companies 481
­Insurance ­Corporation (FSLIC) 429 Size, Structure, and Composition of the
Reform of Deposit Insurance 430 Industry 481
Non–U.S. Deposit Insurance Systems 431 Balance Sheets and Recent Trends 486
Regulation 489
Balance Sheet Regulations 431
Regulations on Commercial Bank Property–Casualty Insurance Companies 490
Liquidity 431 Size, Structure, and Composition of the
Regulations on Capital Adequacy Industry 490
(Leverage) 432 Balance Sheets and Recent Trends 492
Regulation 500
Foreign versus Domestic Regulation
Global Issues 501
of Commercial Banks 437
Product Diversification Activities 437 16 Securities Firms and Investment
Global or International Expansion Activities 438
Banks 506
Appendix 13A: Calculating Deposit Insurance
Services Offered by Securities Firms versus
Premium Assessments 445
­Investment Banks: Chapter Overview 506
Appendix 13B: Calculating Minimum Required
Size, Structure, and Composition of the
Reserves at U.s. ­Depository Institutions 450
Industry 508
Appendix 13C: Primary Regulators of
Securities Firm and Investment Bank Activity
Depository Institutions 453
Areas 510
Appendix 13D: Deposit Insurance Coverage for Investment Banking 510
Commercial Banks in Various Countries 453 Venture Capital 512
Appendix 13E: Calculating Risk-Based Capital Market Making 514
Ratios 453 Trading 514
Investing 515

part 4 OTHER FINANCIAL

Cash Management 516
Mergers and Acquisitions 516
INSTITUTIONS 454 Other Service Functions 516

14 Other Lending Institutions 454 Recent Trends and Balance Sheets 517
Recent Trends 517
Other Lending Institutions: Chapter Balance Sheets 520
Overview 454 Regulation 522
Savings Institutions 455 Global Issues 525
 Contents xxi

17 Investment Companies 531 Liquidity Risk 589

Interest Rate Risk 590
Investment Companies: Chapter Overview 531
Market Risk 592
Size, Structure, and Composition of the Mutual
Fund Industry 532 Off-Balance-Sheet Risk 594
Historical Trends 532 Foreign Exchange Risk 596
Different Types of Mutual Funds 533
Country or Sovereign Risk 598
Other Types of Investment Company
Funds 538 Technology and Operational Risk 598
Mutual Fund Returns and Costs 539 Insolvency Risk 600
Mutual Fund Prospectuses and Objectives 539 Other Risks and Interaction among Risks 600
Investor Returns from Mutual Fund
Ownership 542
Mutual Fund Costs 544 20 Managing Credit Risk on the Balance
Sheet 604
Mutual Fund Balance Sheets and Recent
Trends 547 Credit Risk Management: Chapter
Long-Term Funds 547 Overview 604
Money Market Funds 548
Credit Quality Problems 606
Mutual Fund Regulation 549
Credit Analysis 607
Mutual Fund Global Issues 552 Real Estate Lending 608
Hedge Funds 552 Consumer (Individual) and Small-Business
Types of Hedge Funds 555 Lending 611
Fees on Hedge Funds 558 Mid-Market Commercial and Industrial
Offshore Hedge Funds 559 Lending 612
Regulation of Hedge Funds 560 Large Commercial and Industrial Lending 620
Calculating the Return on a Loan 624
18 Pension Funds 564 Return on Assets (ROA) 624
RAROC Models 626
Pension Funds Defined: Chapter Overview 564
Appendix 20A: Loan Portfolio Risk and
Size, Structure, and Composition of the Management 631
Industry 565
Defined Benefit versus Defined Contribution
Pension Funds 565 21 Managing Liquidity Risk on the
Insured versus Noninsured Pension Funds 567 Balance Sheet 632
Private Pension Funds 568
Liquidity Risk Management: Chapter
Public Pension Funds 575
Overview 632
Financial Asset Investments and Recent
Causes of Liquidity Risk 633
Trends 576
Private Pension Funds 576 Liquidity Risk and Depository Institutions 634
Public Pension Funds 577 Liability-Side Liquidity Risk 634
Asset-Side Liquidity Risk 637
Regulation 579
Measuring a DI’s Liquidity Exposure 638
Global Issues 581 Liquidity Risk, Unexpected Deposit Drains, and
Appendix 18A: Calculation of Growth in Bank Runs 643
IRA Value during an ­Individual’s Working Bank Runs, the Discount Window, and Deposit
Insurance 644
Years 584
Liquidity Risk and Insurance Companies 647
part 5 RISK MANAGEMENT IN FINANCIAL Life Insurance Companies 647
Property–Casualty Insurance Companies 648
INSTITUTIONS 585
Guarantee Programs for Life and
Property–Casualty Insurance
19 Types of Risks Incurred by Financial Companies 649
Institutions 585
Liquidity Risk and Investment Funds 649
Why Financial Institutions Need to Manage Appendix 21A: Sources and Uses of Funds
Risk: Chapter Overview 585 Statement: J.P. Morgan Chase, September
Credit Risk 586 2016 654
xxii Contents
Appendix 21B: New Liquidity Risk Measures
Implemented by the Bank for International
Settlements 654
22 Managing Interest Rate Risk and
Insolvency Risk on the Balance
Sheet 655
Interest Rate and Insolvency Risk Management:
­Chapter Overview 655
Interest Rate Risk Measurement and
Management 656
Repricing Gap Model 656
Duration Gap Model 665
Insolvency Risk Management 673
Capital and Insolvency Risk 673
23 Managing Risk off the Balance
Sheet with Derivative Securities
Derivative Securities used to Manage Risk:
Chapter Overview 683
Forward and Futures Contracts 684
Hedging with Forward Contracts 685
Hedging with Futures Contracts 686
Options 689
Basic Features of Options 689
Actual Interest Rate Options 692
Hedging with Options 692
Caps, Floors, and Collars 693
Risks Associated with Futures, Forwards, and
Options 694
Swaps 695
Hedging with Interest Rate Swaps 695
Hedging with Currency Swaps 698
Credit Swaps 699
Credit Risk Concerns with Swaps 702
Comparison of Hedging Methods 703
Writing versus Buying Options 703
Futures versus Options Hedging 705
Swaps versus Forwards, Futures, and
Options 706
Appendix 23A: Hedging with Futures
Contracts 711
Appendix 23B: Hedging with Options 711
Appendix 23C: Hedging with Caps, Floors, and
Collars 711
24 Managing Risk off the Balance
Sheet with Loan Sales and
Securitization 712
Why Financial Institutions Sell and Securitize
Loans: Chapter Overview 712
Loan Sales 713
683 Types of Loan Sales Contracts 715
The Loan Sales Market 715
Secondary Market for Less Developed Country
Debt 718
Factors Encouraging Future Loan Sales
Growth 719
Factors Deterring Future Loan Sales
Growth 720
Loan Securitization 721
Pass-Through Security 721
Collateralized Mortgage Obligation 728
Mortgage-Backed Bond 732
Securitization of Other Assets 734
Can All Assets Be Securitized? 734
References 739
Index 741
 Introduction and Overview of Financial Markets part one

Introduction chapter

Learning Goals
1
O U T L I N E

LG 1-1 Differentiate between primary and secondary markets. Why Study Financial Markets
and Institutions? Chapter
LG 1-2 Differentiate between money and capital markets. Overview
Overview of Financial Markets
LG 1-3 Understand what foreign exchange markets are.
Primary Markets versus
Secondary Markets
LG 1-4 Understand what derivative security markets are.
Money Markets versus
LG 1-5 Distinguish between the different types of financial institutions. Capital Markets
Foreign Exchange Markets
LG 1-6 Know the services financial institutions perform. Derivative Security Markets
Financial Market
LG 1-7 Know the risks financial institutions face.
Regulation
LG 1-8 Appreciate why financial institutions are regulated. Overview of Financial
Institutions
LG 1-9 Recognize that financial markets are becoming increasingly global. Unique Economic
Functions Performed by
Financial Institutions
Additional Benefits FIs
Provide to Suppliers of
Funds
WHY STUDY FINANCIAL MARKETS AND INSTITUTIONS?
Economic Functions FIs
­CHAPTER OVERVIEW Provide to the Financial
In the 1990s, financial markets in the United States boomed. As seen in Figure 1–1, the System as a Whole
Dow Jones Industrial Index—a widely quoted index of the values of 30 large corpora- Risks Incurred by Financial
tions (see Chapter 8)—rose from a level of 2,800 in January 1990 to more than 11,000 Institutions
by the end of the decade; this compares to a move from 100 at its inception in 1906 to
Regulation of Financial
2,800 eighty-four years later. In the early 2000s, as a result of an economic downturn
Institutions
in the United States and elsewhere, this index fell back below 10,000. The index rose to
over 14,000 in July 2007, but (because of an increasing mortgage market credit crunch, Trends in the United States
particularly the subprime mortgage market) fell back to below 13,000 within a month Globalization of Financial
of hitting the all-time high. By 2008, problems in the subprime mortgage market esca- Markets and Institutions
lated to a full-blown financial crisis and the worst recession in the United States since Appendix 1A: The Financial
the Great Depression. The Dow Jones Industrial Average (DJIA) fell to 6,547 in March Crisis: The Failure of Financial
2009 before recovering, along with the economy, to over 11,000 in April 2010. How- Institutions’ Specialness
ever, it took until March 5, 2013, for the DJIA to surpass its pre-crisis high of 14,164.53, (available through Connect
closing at 14,253.77 for the day, and the DJIA rose to over 21,000 in mid-2017. or your course instructor)

1
2 Part 1 Introduction and Overview of Financial Markets

Figure 1–1 The Dow Jones Industrial Average, 1989–2016

Index Value DJIA Index Value

19,000
18,000
17,000
16,000
15,000
14,000
13,000
12,000
11,000
10,000
9,000
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0 Date
Jan-89
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-13
Jan-14
Jan-15
Jan-16
During the financial crisis of 2008–2009, market swings seen in the United States
quickly spread worldwide. Stock markets saw huge swings in value as investors tried
to sort out who might survive and who would not (and markets from Russia to Europe
were forced to suspend trading as stock prices plunged). As U.S. markets recovered in
2010–2013 and, as mentioned earlier, surpassed their pre-crisis highs, European stock
markets struggled as Greece battled with a severe debt crisis that eventually spread to
other European nations with fiscal problems, such as Portugal, Spain, and Italy. Even the
growth in the robust Chinese economy slowed to 6.7 percent in 2016, the lowest level in
seven years.
World markets were rocked again in June 2016 when the people of the United ­Kingdom
voted to leave the European Union (EU) after 43 years (dubbed “Brexit”). The shock from
the UK’s surprise vote to leave the EU swept across global markets, triggering steep drops
in stock markets and the British pound and a flight into safe assets such as U.S. bonds and
gold. The pound fell more than 11 percent to its lowest point since 1985. The DJIA dropped
610.32 points, or 3.4 percent. The Stoxx Europe 600 index fell 7 percent, its steepest drop
since 2008, while Japan’s Nikkei Stock Average declined 7.9 percent. Bonds also sold off
sharply, pushing UK government borrowing costs sharply higher, as traders and investors
grappled with the market implications of Brexit. The UK had its credit rating outlook cut to
“negative” by the ratings agency Moody’s.
The UK’s vote to leave the European Union shook the region, precipitating an imme-
diate political crisis in Britain and shifting the path of a European project created to bind a
continent torn by World War II. Prime Minister David Cameron, who had led the campaign
to stay inside the 28-nation bloc, announced he would step down, setting off a leadership
contest among Conservatives. Britain’s decision, one of the most momentous by a Western
country in the past 50 years, reverses the course of expansion for the EU. It had grown over
decades to include most of Europe, absorbing former dictatorships in Greece, Spain, and
Portugal, and the countries of the east, formerly under Soviet domination. The UK would
be the first member nation to leave, a step some leaders warned beforehand would diminish
the global influence of the UK and the EU and risk setting in motion the European bloc’s
eventual disintegration. The vote also raised questions about whether the UK itself would
split. After a large majority of Scottish citizens voted to remain a part of the EU, Scotland’s
First Minister said the Scottish National Party would seek to hold a new referendum on the
country’s exit from the EU.
 Chapter 1 Introduction 3

Originally the banking industry operated as a full-service industry, performing directly

or indirectly all financial services (commercial banking, investment banking, stock invest-
ing, insurance provision, etc.). In the early 1930s, the economic and industrial collapse
resulted in the separation of some of these activities. In the 1970s and 1980s new, rela-
tively unregulated financial services industries sprang up (e.g., mutual funds, brokerage
funds) that separated the financial service functions even further.
The last 30 years, however, have seen a reversal of these trends. In the 1990s and
2000s, regulatory barriers, technology, and financial innovation changes were such that
a full set of financial services could again be offered by a single financial services firm
under the umbrella of a financial services holding company. For example, J.P. Morgan
Chase & Co. operates a commercial bank (J.P. Morgan Chase Bank), an investment
bank (J. P. ­Morgan Securities, which also sells mutual funds), and an insurance company
(J. P. ­Morgan ­Insurance Agency). Not only did the boundaries between traditional industry
sectors change, but competition became global in nature as well. For example, J.P. Morgan
Chase is the world’s seventh-largest bank holding company, operating in 60 countries.
The financial crisis produced another reshaping of all financial institution (FI) sectors
and the end of many major FIs (e.g., Bear Stearns and Lehman Brothers), with the two most
prominent investment banks in the world, Goldman Sachs and Morgan Stanley, converting
to bank holding company status. Indeed, as of 2010, all the major U.S. investment banks
had either failed, been acquired by a commercial bank, or become bank holding compa-
nies. Further, legislation enacted as a result of the financial crisis represents an attempt to
again separate FI activities. For example, the “Volcker Rule” provision of the Wall Street
Reform and Consumer Protection Act prohibits bank holding companies from engaging in
proprietary trading and limits their investments in hedge funds, private equity, and related
vehicles. Despite these most recent changes, many FIs operate in more than one FI sector.
As economic and competitive environments change, attention to profit and, more
than ever, risk becomes increasingly important. This book provides a detailed overview
and analysis of the financial system in which financial managers and individual investors
operate. Making investment and financing decisions requires managers and individuals to
understand the flow of funds throughout the economy as well as the operation and struc-
ture of domestic and international financial markets. In particular, this book offers a unique
analysis of the risks faced by investors and savers, as well as strategies that can be adopted
for controlling and managing these risks. Newer areas of operations such as asset securi-
tization, derivative securities, and internationalization of financial services also receive
special emphasis. Further, as the United States and the world continue to recover from
the collapse of the financial markets, this book highlights and discusses the impact of this
crisis on the various financial markets and the financial institutions that operate in them.
This introductory chapter provides an overview of the structure and operations of
various financial markets and financial institutions. Financial markets are differentiated
by the characteristics (such as maturity) of the financial instruments or securities that are
exchanged. Moreover, each financial market, in turn, depends in part or in whole on finan-
cial institutions. Indeed, FIs play a special role in the functioning of financial markets. In
particular, FIs often provide the least costly and most efficient way to channel funds to and
from financial markets. As part of this discussion, we briefly examine how changes in the
way FIs deliver services played a major part in the events leading up to the severe financial
crisis of the late 2000s. A more detailed discussion of the causes of, the major events dur-
ing, and the regulatory and industry changes resulting from the financial crisis is provided
in Appendix 1A to the chapter (available through Connect or your course instructor).

OVERVIEW OF FINANCIAL MARKETS

financial markets Financial markets are structures through which funds flow. Table 1–1 summarizes the
The arenas through which financial markets discussed in this section. Financial markets can be distinguished along
funds flow. two major dimensions: (1) primary versus secondary markets and (2) money versus capital
markets. The next sections discuss each of these dimensions.
4 Part 1 Introduction and Overview of Financial Markets

TABLE 1–1 Types of Financial Markets

Primary markets—markets in which corporations raise funds through new issues of securities.
Secondary markets—markets that trade financial instruments once they are issued.
Money markets—markets that trade debt securities or instruments with maturities of less than
one year.
Capital markets—markets that trade debt and equity instruments with maturities of more than
one year.
Foreign exchange markets—markets in which cash flows from the sale of products or assets
denominated in a foreign currency are transacted.
Derivative markets—markets in which derivative securities trade.

LG 1-1 Primary Markets versus Secondary Markets

primary markets
Markets in which corpora-
tions raise funds through
new issues of securities.
initial public offering
(IPO)
The first public issue of a
financial instrument by a
firm.
Primary Markets. Primary markets are markets in which users of funds (e.g., corpora-
tions) raise funds through new issues of financial instruments, such as stocks and bonds.
Table 1–2 lists data on primary market sales of securities from 2000 through 2016. Note
the impact the financial crisis had on primary market sales by firms. New issues fell to
$1,068.0 billion in 2008, during the worst of the crisis, from $2,389.1 billion in 2007, pre-
crisis. As of 2015, primary market sales had still not recovered as only $1,843.2 billion
new securities were issued for the year.
Fund users have new projects or expanded production needs, but do not have s­ ufficient
internally generated funds (such as retained earnings) to support these needs. Thus, the
fund users issue securities in the external primary markets to raise additional funds. New
issues of financial instruments are sold to the initial suppliers of funds (e.g., ­households)
in exchange for funds (money) that the issuer or user of funds needs.1 Most primary mar-
ket transactions in the United States are arranged through financial institutions called
investment banks—for example, Morgan Stanley or Bank of America Merrill Lynch—that
serve as intermediaries between the issuing corporations (fund users) and investors (fund
suppliers). For these public offerings, the investment bank provides the securities issuer
(the funds user) with advice on the securities issue (such as the offer price and number of
securities to issue) and attracts the initial public purchasers of the securities for the funds
user. By issuing primary market securities with the help of an investment bank, the funds
user saves the risk and cost of creating a market for its securities on its own (see the fol-
lowing discussion). Figure 1–2 illustrates a time line for the primary market exchange of
funds for a new issue of corporate bonds or equity. We discuss this process in detail in
Chapters 6 and 8.
Primary market financial instruments include issues of equity by firms initially going
public (e.g., allowing their equity—shares—to be publicly traded on stock markets for the
first time). These first-time issues are usually referred to as initial public offerings (IPOs).
For example, on June 16, 2015, Fitbit announced a $732 million IPO of its common stock.

TABLE 1–2 Primary Market Sales of Securities (in billions of dollars)

Security Type 2000 2005 2007 2008 2010 2012 2015 2016*
All issues $1,256.7 $2,439.0 $2,389.1 $1,068.0 $1,024.7 $1,401.0 $1,843.2 $318.9
Bonds 944.8 2,323.7 2,220.3 861.2 893.7 1,242.5 1,611.3 285.3
Stocks 311.9 115.3 168.8 206.8 131.0 129.5 174.0 33.2
Private placements 196.5 24.6 20.1 16.2 22.2 21.4 28.8 n.a.†
IPOs 97.0 36.7 46.3 26.4 37.0 40.9 29.1 0.4

*Through first quarter.

†n.a. = not applicable.

1. We discuss the users and suppliers of funds in more detail in Chapter 2.


secondary market
A market that trades finan-
cial instruments once they
are issued.
derivative security
A financial security whose
payoffs are linked to other,
previously issued securi-
ties or indices.
Chapter 1 Introduction 5
Figure 1–2 Primary and Secondary Market Transfer of Funds Time Line
Primary Markets
(Where new issues of financial instruments are offered for sale)
Users of Funds
Initial Suppliers
(Corporations Underwriting with
of Funds
issuing debt/equity Investment Bank
(Investors)
instruments)
Secondary Markets
(Where financial instruments, once issued, are traded)
Economic Agents Economic Agents
(Investors) Wanting Financial Markets (Investors) Wanting
to Sell Securities to Buy Securities
Financial instruments flow
Funds flow
The company’s stock was underwritten by several investment banks, including Morgan
Stanley, Deutsche Bank, and Bank of America Merrill Lynch. Primary market securities
also include the issue of additional equity or debt instruments of an already publicly traded
firm. For example, on January 28, 2016, Molson Coors Brewing Company announced the
sale of an additional 29.88 million shares of common stock underwritten by investment
banks such as UBS, Bank of America Merrill Lynch, and Citigroup.
Secondary Markets. Once financial instruments such as stocks are issued in primary
markets, they are then traded—that is, rebought and resold—in secondary markets.
For example, on April 12, 2016, 9.7 million shares of ExxonMobil were traded in the
­secondary stock market. Buyers of secondary market securities are economic agents
(consumers, businesses, and governments) with excess funds. Sellers of secondary mar-
ket financial instruments are economic agents in need of funds. Secondary markets pro-
vide a centralized marketplace where economic agents know they can transact quickly
and efficiently.
These markets therefore save economic agents the search and other costs of seeking
buyers or sellers on their own. Figure 1–2 illustrates a secondary market transfer of funds.
When an economic agent buys a financial instrument in a secondary market, funds are
exchanged, usually with the help of a securities broker such as Charles Schwab acting as
an intermediary between the buyer and the seller of the instrument (see Chapter 8). The
original issuer of the instrument (user of funds) is not involved in this transfer. The New
York Stock Exchange (NYSE) and the National Association of Securities Dealers Auto-
mated Quotation (NASDAQ) system are two well-known examples of secondary markets
for trading stocks. We discuss the details of each of these markets in Chapter 8.
In addition to stocks and bonds, secondary markets also exist for financial instruments
backed by mortgages and other assets (see Chapter 7), foreign exchange (see Chapter 9),
and futures and options (i.e., derivative securities—financial securities whose payoffs
6 Part 1 Introduction and Overview of Financial Markets
liquidity
The ease with which an
asset can be converted
into cash quickly and at
fair market value.
LG 1-2
money markets
Markets that trade debt
securities or instruments
with maturities of one year
or less.
over-the-counter
(OTC) markets
Markets that do not
operate in a specific
fixed ­location—rather,
­transactions occur via tele-
phones, wire transfers, and
computer trading.
are linked to other, previously issued [or underlying] primary securities or indexes of pri-
mary securities) (see Chapter 10). As we will see in Chapter 10, derivative securities have
existed for centuries, but the growth in derivative securities markets occurred mainly in the
1980s through 2000s. As major markets, therefore, derivative securities markets are among
the newest of the financial security markets.
Secondary markets offer benefits to both investors (suppliers of funds) and issuing
corporations (users of funds). For investors, secondary markets provide the opportunity to
trade securities at their market values quickly as well as to purchase securities with vary-
ing risk-return characteristics (see Chapter 2). Corporate security issuers are not directly
involved in the transfer of funds or instruments in the secondary market. However, the
issuer does obtain information about the current market value of its financial instruments,
and thus the value of the corporation as perceived by investors such as its stockholders,
through tracking the prices at which its financial instruments are being traded on second-
ary markets. This price information allows issuers to evaluate how well they are using
the funds generated from the financial instruments they have already issued and provides
information on how well any subsequent offerings of debt or equity might do in terms of
raising additional money (and at what cost).
Secondary markets offer buyers and sellers liquidity—the ability to turn an asset into
cash quickly at its fair market value—as well as information about the prices or the value
of their investments. Increased liquidity makes it more desirable and easier for the issuing
firm to sell a security initially in the primary market. Further, the existence of centralized
markets for buying and selling financial instruments allows investors to trade these instru-
ments at low transaction costs.
Money Markets versus Capital Markets
Money Markets. Money markets are markets that trade debt securities or instruments
with maturities of one year or less (see Figure 1–3). In the money markets, economic
agents with short-term excess supplies of funds can lend funds (i.e., buy money mar-
ket instruments) to economic agents who have short-term needs or shortages of funds
(i.e., they sell money market instruments). The short-term nature of these instruments
means that fluctuations in their prices in the secondary markets in which they trade are
usually quite small (see Chapters 3 and 22 on interest rate risk). In the United States,
money markets do not operate in a specific location—rather, transactions occur via tele-
phones, wire transfers, and computer trading. Thus, most U.S. money markets are said to
be over-the-counter (OTC) markets.
Money Market Instruments. A variety of money market securities are issued by
corporations and government units to obtain short-term funds. These securities include
Treasury bills, federal funds, repurchase agreements, commercial paper, negotiable
certificates of deposit, and banker’s acceptances. Table 1–3 lists and defines the major
money market securities. Figure 1–4 shows outstanding amounts of money market
instruments in the United States in 1990, 2000, 2010, and 2016. Notice that in 2016
federal funds and repurchase agreements, followed by negotiable CDs, Treasury bills,
and commercial paper, had the largest amounts outstanding. Money market instru-
ments and the operation of the money markets are described and discussed in detail in
Chapter 5.
Figure 1–3 Money versus Capital Market Maturities
Capital Market Securities
Money Market
Securities Notes and Bonds Stocks (Equities) Maturity
0 1 year to 30 years to No specified
maturity maturity maturity
 Chapter 1 Introduction 7

TABLE 1–3 Money and Capital Market Instruments

MONEY MARKET INSTRUMENTS

Treasury bills—short-term obligations issued by the U.S. government.

Federal funds—short-term funds transferred between financial institutions usually for no more
than one day.
Repurchase agreements—agreements involving the sale of securities by one party to another with a
promise by the seller to repurchase the same securities from the buyer at a specified date and price.
Commercial paper—short-term unsecured promissory notes issued by a company to raise
short-term cash.
Negotiable certificates of deposit—bank-issued time deposits that specify an interest rate and
maturity date and are negotiable (i.e., can be sold by the holder to another party).
Banker’s acceptances—time drafts payable to a seller of goods, with payment guaranteed by
a bank.

CAPITAL MARKET INSTRUMENTS

Corporate stock—the fundamental ownership claim in a public corporation.

Mortgages—loans to individuals or businesses to purchase a home, land, or other real property.
Corporate bonds—long-term bonds issued by corporations.
Treasury bonds—long-term bonds issued by the U.S. government.
State and local government bonds—long-term bonds issued by state and local governments.
U.S. government agency bonds—long-term bonds collateralized by a pool of assets and issued
by agencies of the U.S. government.
Bank and consumer loans—loans to commercial banks and individuals.

Figure 1–4 Money Market Instruments Outstanding

1990 2000
$2.06 trillion $4.51 trillion
outstanding outstanding

18.1% 26.5%
27.1% 35.6%

2.6%
25.7% 14.4%
26.5% 23.3%
0.2%

2010 2016
$6.5 trillion $7.97 trillion
outstanding outstanding

25.6%
45.8%
16.7%
11.8%
Federal funds and repurchase
28.6% agreements
0.0%
0.0% 23.4% Commercial paper
29.1% 19.0% U.S. Treasury bills
Negotiable CDs
Banker’s acceptances
Sources: Federal Reserve Board, “Financial Accounts of the United States,” Statistical Releases, Washington, DC, various issues. www
.federalreserve.gov
8 Part 1 Introduction and Overview of Financial Markets

capital markets
Markets that trade debt
(bonds) and equity (stocks)
instruments with maturities
of more than one year.
Capital Markets. Capital markets are markets that trade equity (stocks) and debt
(bonds) instruments with maturities of more than one year (see Figure 1–3). The major
suppliers of capital market securities (or users of funds) are corporations and govern-
ments. Households are the major suppliers of funds for these securities. Given their
longer maturity, these instruments experience wider price fluctuations in the second-
ary markets in which they trade than do money market instruments. For example, all
else constant, long-term maturity debt instruments experience wider price fluctuations
for a given change in interest rates than short-term maturity debt instruments (see
Chapter 3).

Capital Market Instruments. Table 1–3 lists and defines the major capital market secu-
rities. Figure 1–5 shows their outstanding amounts by dollar market value. Notice that in
2000, 2010, and 2016, corporate stocks or equities represent the largest capital market
instrument, followed by mortgages and corporate bonds. The relative size of the market
value of capital market instruments outstanding depends on two factors: the number of

Figure 1–5 Capital Market Instruments Outstanding

1990 2000
$14.93 trillion $40.6 trillion
outstanding outstanding

3.7%
16.8%
25.5% 23.6%

10.6% 43.4%
7.9% 11.4%
7.7%
9.6% 11.1%
10.9% 12.1%
5.7%

2010 2016
$67.9 trillion $90.2 trillion
outstanding outstanding

4.2% 4.1% 15.3%

20.9%

11.4% 9.0%
31.3% 49.6%
3.9%
6.4% 9.0% 15.1%
16.8% 13.0%

Corporate stocks State and local government bonds

Mortgages U.S. government agency bonds
Corporate bonds Consumer loans
Treasury securities

Sources: Federal Reserve Board, “Financial Accounts of the United States,” Statistical Releases,
Washington, DC, various issues. www.federalreserve.gov
 Chapter 1 Introduction 9

securities issued and their market prices.2 One reason for the sharp increase in the value of
equities outstanding is the bull market in stock prices in the 1990s. Stock values fell in the
early 2000s as the U.S. economy experienced a downturn—partly because of 9/11 and
partly because interest rates began to rise—and stock prices fell. Stock prices in most sec-
tors subsequently recovered and, by 2007, even surpassed their 1999 levels. Stock prices
fell precipitously during the financial crisis of 2008–2009. As of mid-March 2009, the
Dow Jones Industrial Average (DJIA) had fallen 53.8 percent in value in less than 1½
years, larger than the decline during the market crash of 1929 when it fell 49 percent. How-
ever, stock prices recovered, along with the economy, in the last half of 2009, rising 71.1
percent between March 2009 and April 2010. Capital market instruments and their opera-
tions are discussed in detail in Chapters 6, 7, and 8.

LG 1-3 Foreign Exchange Markets

In addition to understanding the operations of domestic financial markets, a financial man-
ager must also understand the operations of foreign exchange markets and foreign capi-
tal markets. Today’s U.S.-based companies operate globally. It is therefore essential that
financial managers understand how events and movements in financial markets in other
countries affect the profitability and performance of their own companies. For example, in
2015 a strengthening dollar reduced profits for internationally active firms. IBM experi-
enced a drop in its 2015 earnings per share of $1.10 due to foreign exchange trends. Coca-
Cola, which gets the majority of its sales from outside the United States, saw 2015 revenues
decrease by 5.1 percent as the U.S. dollar strengthened relative to foreign currencies.
Cash flows from the sale of securities (or other assets) denominated in a for-
D O YO U U N D E R S TA N D : eign currency expose U.S. corporations and investors to risk regarding the value at
which foreign currency cash flows can be converted into U.S. dollars. For example,
1. The difference between primary
the actual amount of U.S. dollars received on a foreign investment depends on the
and secondary markets?
exchange rate between the U.S. dollar and the foreign currency when the nondollar
2. The major distinction between
money markets and capital
cash flow is converted into U.S. dollars. If a foreign currency depreciates (declines
markets? in value) relative to the U.S. dollar over the investment period (i.e., the period
3. What the major instruments between the time a foreign investment is made and the time it is terminated), the
traded in the capital markets dollar value of cash flows received will fall. If the foreign currency appreciates, or
are? rises in value, relative to the U.S. dollar, the dollar value of cash flows received on
4. What happens to the dollar the foreign investment will increase.
value of a U.S. investor’s While foreign currency exchange rates are often flexible—they vary day to
holding of British pounds if the day with demand for and supply of a foreign currency for dollars—central govern-
pound appreciates (rises) in
value against the dollar?
ments sometimes intervene in foreign exchange markets directly or affect foreign
exchange rates indirectly by altering interest rates. We discuss the motivation and
5. What derivative security
markets are? effects of these interventions in Chapters 4 and 9. The sensitivity of the value of
cash flows on foreign investments to changes in the foreign currency’s price in
terms of dollars is referred to as foreign exchange risk and is discussed in more
detail in Chapter 9. Techniques for managing, or “hedging,” foreign exchange risk, such
as using derivative securities like foreign exchange (FX) futures, options, and swaps, are
discussed in Chapter 23.

LG 1-4 Derivative Security Markets

derivative security
markets
The markets in which
derivative securities trade.
Derivative security markets are markets in which derivative securities trade. A ­derivative
security is a financial security (such as a futures contract, option contract, swap contract,
or mortgage-backed security) whose payoff is linked to another, previously issued secu-
rity such as a security traded in capital or foreign exchange markets. Derivative securities
generally involve an agreement between two parties to exchange a standard quantity of an
asset or cash flow at a predetermined price and at a specified date in the future. As the

2. For example, the market value of equity is the product of the price of the equity times the number of shares that are
issued.
10
derivative security
An agreement between
two parties to exchange
a standard quantity of an
asset at a predetermined
price at a specified date in
the future.
www.sec.gov
Part 1 Introduction and Overview of Financial Markets
value of the underlying security to be exchanged changes, the value of the derivative secu-
rity changes. While derivative securities have been in existence for centuries, the growth
in derivative security markets occurred mainly in the 1990s and 2000s. Table 1–4 shows
the dollar (or notional) value of derivatives held by commercial banks from 1992 through
2016. Note the tremendous growth in these securities between 1992 and 2013, and the
large drop from 2013 to 2016. As we discuss in Chapter 10, part of the Wall Street Reform
and Consumer Protection Act, passed in 2010 in response to the financial crisis, is the Vol-
cker Rule which prohibits U.S. depository institutions (DIs) from engaging in proprietary
trading (i.e., trading as a principal for the trading account of the bank). This includes any
transaction to purchase or sell derivatives. Thus, only the investment banking arm of the
business is allowed to conduct such trading. The Volcker Rule was implemented in April
2014 and banks had until July 21, 2015, to be in compliance. The result has been a reduc-
tion in derivative securities held off-balance-sheet by these financial institutions.
As major markets, derivative security markets are the newest of the financial security
markets. Derivative securities, however, are also potentially the riskiest of the financial
securities. Indeed, at the center of the recent financial crisis were losses associated with
off-balance-sheet mortgage-backed (derivative) securities created and held by FIs. Losses
from the falling value of subprime mortgages and the derivative securities backed by these
mortgages reached $700 billion worldwide by early 2009 and resulted in the failure, acqui-
sition, or bailout of some of the largest FIs and the near collapse of the world’s financial
and economic systems.
We discuss derivative security activity in Chapter 10. Derivative security traders can
be either users of derivative contracts for hedging (see Chapters 10 and 23) and other pur-
poses or dealers (such as banks) that act as counterparties in trades with customers for a fee.
Financial Market Regulation
Financial instruments are subject to regulations imposed by regulatory agencies such as
the Securities and Exchange Commission (SEC)—the main regulator of securities markets
since the passage of the Securities Act of 1934—as well as the exchanges (if any) on which
the instruments are traded. The main emphasis of SEC regulations (as stated in the Securi-
ties Act of 1933) is on full and fair disclosure of information on securities issues to actual
and potential investors. Those firms planning to issue new stocks or bonds to be sold to
the public at large (public issues) are required by the SEC to register their securities with
the SEC and to fully describe the issue, and any risks associated with the issue, in a legal
document called a prospectus.
The SEC also monitors trading on the major exchanges (along with the exchanges
themselves) to ensure that stockholders and managers do not trade on the basis of inside
information about their own firms (i.e., information prior to its public release). SEC regu-
lations are not intended to protect investors against poor investment choices, but rather to
ensure that investors have full and accurate information available about corporate issuers
when making their investment decisions.
TABLE 1–4 Derivative Contracts Held by Commercial Banks, by Contract Product
(in billions of dollars)
1992 2000 2008 2013 2016
Futures and forwards $4,780 $ 9,877 $ 22,512 $ 45,599 $ 35,685
Swaps 2,417 21,949 131,706 138,361 107,393
Options 1,568 8,292 30,267 33,760 30,909
Credit derivatives — 426 15,897 13,901 6,986
Total $8,765 $40,544 $ 200,382 $231,621 $180,973
Note: Em dashes represent values that are too small to register.
Sources: Office of the Comptroller of the Currency website, various dates. www.occ.treas.gov
 Chapter 1 Introduction 11

OVERVIEW OF FINANCIAL INSTITUTIONS

LG 1-5 Financial institutions (e.g., commercial and savings banks, credit unions, insurance
companies, mutual funds) perform the essential function of channeling funds from those
with surplus funds (suppliers of funds) to those with shortages of funds (users of funds).
financial institutions ­Chapters 11 through 18 discuss the various types of FIs in today’s economy, including
(1) the size, structure, and composition of each type; (2) their balance sheets and recent
Institutions that perform
trends; (3) FI performance; and (4) the regulators who oversee each type. Table 1–5 lists
the essential function of
and summarizes the FIs discussed in detail in later chapters.
channeling funds from
those with surplus funds To understand the important economic function financial institutions play in the
to those with shortages of operation of financial markets, imagine a simple world in which FIs do not exist. In such
funds. a world, suppliers of funds (e.g., households), generating excess savings by consuming
less than they earn, would have a basic choice: they could either hold cash as an asset
direct transfer or directly invest that cash in the securities issued by users of funds (e.g., corporations or
A corporation sells its households). In general, users of funds issue financial claims (e.g., equity and debt securi-
stock or debt directly to ties or mortgages) to finance the gap between their investment expenditures and their inter-
investors without going nally generated savings such as retained earnings. As shown in Figure 1–6, in such a world
through a financial we have a direct transfer of funds (money) from suppliers of funds to users of funds. In
institution. return, financial claims would flow directly from users of funds to suppliers of funds.

TABLE 1–5 Types of Financial Institutions

Commercial banks—depository institutions whose major assets are loans and whose major
liabilities are deposits. Commercial banks’ loans are broader in range, including consumer,
commercial, and real estate loans, than are those of other depository institutions. Commercial
banks’ liabilities include more nondeposit sources of funds, such as subordinate notes and
debentures, than do those of other depository institutions.
Thrifts—depository institutions in the form of savings associations, savings banks, and credit
unions. Thrifts generally perform services similar to commercial banks, but they tend to
concentrate their loans in one segment, such as real estate loans or consumer loans.
Insurance companies—financial institutions that protect individuals and corporations
(policyholders) from adverse events. Life insurance companies provide protection in the
event of untimely death, illness, and retirement. Property casualty insurance protects against
personal injury and liability due to accidents, theft, fire, and so on.
Securities firms and investment banks—financial institutions that help firms issue securities
and engage in related activities such as securities brokerage and securities trading.
Finance companies—financial intermediaries that make loans to both individuals and
businesses. Unlike depository institutions, finance companies do not accept deposits but
instead rely on short- and long-term debt for funding.
Investment funds—financial institutions that pool financial resources of individuals and companies
and invest those resources in diversified portfolios of assets.
Pension funds—financial institutions that offer savings plans through which fund participants
accumulate savings during their working years before withdrawing them during their
retirement years. Funds originally invested in and accumulated in pension funds are exempt
from current taxation.

Figure 1–6 Flow of Funds in a World without FIs

Financial Claims
(equity and debt instruments)

Users of Funds Suppliers of Funds

Cash
12 Part 1 Introduction and Overview of Financial Markets

In this economy without financial institutions, the level of funds flowing between sup-
pliers of funds (who want to maximize the return on their funds subject to risk) and users
of funds (who want to minimize their cost of borrowing subject to risk) is likely to be quite
low. There are several reasons for this. First, once they have lent money in exchange for
financial claims, suppliers of funds need to monitor continuously the use of their funds.
They must be sure that the user of funds neither steals the funds outright nor wastes the
funds on projects that have low or negative returns. Such monitoring is often extremely
costly for any given fund supplier because it requires considerable time, expense, and
effort to collect this information relative to the size of the average fund supplier’s invest-
ment. Given this, fund suppliers would likely prefer to leave, or delegate, the monitoring
of fund borrowers to others. The resulting lack of monitoring increases the risk of directly
investing in financial claims.
Second, the relatively long-term nature of many financial claims (e.g., mortgages,
corporate stock, and bonds) creates another disincentive for suppliers of funds to hold the
direct financial claims issued by users of funds. Specifically, given the choice between
holding cash and long-term securities, fund suppliers may well choose to hold cash for
liquidity reasons, especially if they plan to use their savings to finance consumption expen-
ditures in the near future and financial markets are not very developed, or deep, in terms of
the number of active buyers and sellers in the market.
Third, even though real-world financial markets provide some liquidity services, by
allowing fund suppliers to trade financial securities among themselves, fund suppliers face
price risk a price risk upon the sale of securities. That is, the price at which investors can sell a secu-
The risk that an asset’s rity on secondary markets such as the New York Stock Exchange (NYSE) may well differ
sale price will be lower from the price they initially paid for the security either because investors change their valu-
than its purchase price. ation of the security between the time it was bought and when it was sold and/or because
dealers, acting as intermediaries between buyers and sellers, charge transaction costs for
completing a trade.

Unique Economic Functions Performed by Financial Institutions

Because of (1) monitoring costs, (2) liquidity costs, and (3) price risk, the average investor
in a world without FIs would likely view direct investment in financial claims and markets
as an unattractive proposition and prefer to hold cash. As a result, financial market activity
indirect transfer (and therefore savings and investment) would likely remain quite low.
A transfer of funds However, the financial system has developed an alternative and indirect way for inves-
between suppliers and tors (or fund suppliers) to channel funds to users of funds.3 This is the indirect transfer of
users of funds through a funds to the ultimate user of funds via FIs. Due to the costs of monitoring, liquidity risk,
financial intermediary. and price risk, as well as for other reasons explained later, fund suppliers often prefer to

Figure 1–7 Flow of Funds in a World with FIs

Users of Funds FI Suppliers of Funds

(Brokers)

Cash FI Cash
(Asset
transformers)

Financial Claims Financial Claims

(Equity and debt securities) (Deposits and insurance policies)

3. We describe and illustrate this flow of funds in Chapter 2.

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 DANCE ON STILTS AT THE GIRLS’ UNYAGO, NIUCHI

Newala, too, suffers from the distance of its water-supply—at least

the Newala of to-day does; there was once another Newala in a lovely
valley at the foot of the plateau. I visited it and found scarcely a trace
of houses, only a Christian cemetery, with the graves of several
missionaries and their converts, remaining as a monument of its
former glories. But the surroundings are wonderfully beautiful. A
thick grove of splendid mango-trees closes in the weather-worn
crosses and headstones; behind them, combining the useful and the
agreeable, is a whole plantation of lemon-trees covered with ripe
fruit; not the small African kind, but a much larger and also juicier
imported variety, which drops into the hands of the passing traveller,
without calling for any exertion on his part. Old Newala is now under
the jurisdiction of the native pastor, Daudi, at Chingulungulu, who,
as I am on very friendly terms with him, allows me, as a matter of
course, the use of this lemon-grove during my stay at Newala.
 FEET MUTILATED BY THE RAVAGES OF THE “JIGGER”
(Sarcopsylla penetrans)

The water-supply of New Newala is in the bottom of the valley,

some 1,600 feet lower down. The way is not only long and fatiguing,
but the water, when we get it, is thoroughly bad. We are suffering not
only from this, but from the fact that the arrangements at Newala are
nothing short of luxurious. We have a separate kitchen—a hut built
against the boma palisade on the right of the baraza, the interior of
which is not visible from our usual position. Our two cooks were not
long in finding this out, and they consequently do—or rather neglect
to do—what they please. In any case they do not seem to be very
particular about the boiling of our drinking-water—at least I can
attribute to no other cause certain attacks of a dysenteric nature,
from which both Knudsen and I have suffered for some time. If a
man like Omari has to be left unwatched for a moment, he is capable
of anything. Besides this complaint, we are inconvenienced by the
state of our nails, which have become as hard as glass, and crack on
the slightest provocation, and I have the additional infliction of
pimples all over me. As if all this were not enough, we have also, for
the last week been waging war against the jigger, who has found his
Eldorado in the hot sand of the Makonde plateau. Our men are seen
all day long—whenever their chronic colds and the dysentery likewise
raging among them permit—occupied in removing this scourge of
Africa from their feet and trying to prevent the disastrous
consequences of its presence. It is quite common to see natives of
this place with one or two toes missing; many have lost all their toes,
or even the whole front part of the foot, so that a well-formed leg
ends in a shapeless stump. These ravages are caused by the female of
Sarcopsylla penetrans, which bores its way under the skin and there
develops an egg-sac the size of a pea. In all books on the subject, it is
stated that one’s attention is called to the presence of this parasite by
an intolerable itching. This agrees very well with my experience, so
far as the softer parts of the sole, the spaces between and under the
toes, and the side of the foot are concerned, but if the creature
penetrates through the harder parts of the heel or ball of the foot, it
may escape even the most careful search till it has reached maturity.
Then there is no time to be lost, if the horrible ulceration, of which
we see cases by the dozen every day, is to be prevented. It is much
easier, by the way, to discover the insect on the white skin of a
European than on that of a native, on which the dark speck scarcely
shows. The four or five jiggers which, in spite of the fact that I
constantly wore high laced boots, chose my feet to settle in, were
taken out for me by the all-accomplished Knudsen, after which I
thought it advisable to wash out the cavities with corrosive
sublimate. The natives have a different sort of disinfectant—they fill
the hole with scraped roots. In a tiny Makua village on the slope of
the plateau south of Newala, we saw an old woman who had filled all
the spaces under her toe-nails with powdered roots by way of
prophylactic treatment. What will be the result, if any, who can say?
The rest of the many trifling ills which trouble our existence are
really more comic than serious. In the absence of anything else to
smoke, Knudsen and I at last opened a box of cigars procured from
the Indian store-keeper at Lindi, and tried them, with the most
distressing results. Whether they contain opium or some other
narcotic, neither of us can say, but after the tenth puff we were both
“off,” three-quarters stupefied and unspeakably wretched. Slowly we
recovered—and what happened next? Half-an-hour later we were
once more smoking these poisonous concoctions—so insatiable is the
craving for tobacco in the tropics.
Even my present attacks of fever scarcely deserve to be taken
seriously. I have had no less than three here at Newala, all of which
have run their course in an incredibly short time. In the early
afternoon, I am busy with my old natives, asking questions and
making notes. The strong midday coffee has stimulated my spirits to
an extraordinary degree, the brain is active and vigorous, and work
progresses rapidly, while a pleasant warmth pervades the whole
body. Suddenly this gives place to a violent chill, forcing me to put on
my overcoat, though it is only half-past three and the afternoon sun
is at its hottest. Now the brain no longer works with such acuteness
and logical precision; more especially does it fail me in trying to
establish the syntax of the difficult Makua language on which I have
ventured, as if I had not enough to do without it. Under the
circumstances it seems advisable to take my temperature, and I do
so, to save trouble, without leaving my seat, and while going on with
my work. On examination, I find it to be 101·48°. My tutors are
abruptly dismissed and my bed set up in the baraza; a few minutes
later I am in it and treating myself internally with hot water and
lemon-juice.
Three hours later, the thermometer marks nearly 104°, and I make
them carry me back into the tent, bed and all, as I am now perspiring
heavily, and exposure to the cold wind just beginning to blow might
mean a fatal chill. I lie still for a little while, and then find, to my
great relief, that the temperature is not rising, but rather falling. This
is about 7.30 p.m. At 8 p.m. I find, to my unbounded astonishment,
that it has fallen below 98·6°, and I feel perfectly well. I read for an
hour or two, and could very well enjoy a smoke, if I had the
wherewithal—Indian cigars being out of the question.
Having no medical training, I am at a loss to account for this state
of things. It is impossible that these transitory attacks of high fever
should be malarial; it seems more probable that they are due to a
kind of sunstroke. On consulting my note-book, I become more and
more inclined to think this is the case, for these attacks regularly
follow extreme fatigue and long exposure to strong sunshine. They at
least have the advantage of being only short interruptions to my
work, as on the following morning I am always quite fresh and fit.
My treasure of a cook is suffering from an enormous hydrocele which
makes it difficult for him to get up, and Moritz is obliged to keep in
the dark on account of his inflamed eyes. Knudsen’s cook, a raw boy
from somewhere in the bush, knows still less of cooking than Omari;
consequently Nils Knudsen himself has been promoted to the vacant
post. Finding that we had come to the end of our supplies, he began
by sending to Chingulungulu for the four sucking-pigs which we had
bought from Matola and temporarily left in his charge; and when
they came up, neatly packed in a large crate, he callously slaughtered
the biggest of them. The first joint we were thoughtless enough to
entrust for roasting to Knudsen’s mshenzi cook, and it was
consequently uneatable; but we made the rest of the animal into a
jelly which we ate with great relish after weeks of underfeeding,
consuming incredible helpings of it at both midday and evening
meals. The only drawback is a certain want of variety in the tinned
vegetables. Dr. Jäger, to whom the Geographical Commission
entrusted the provisioning of the expeditions—mine as well as his
own—because he had more time on his hands than the rest of us,
seems to have laid in a huge stock of Teltow turnips,[46] an article of
food which is all very well for occasional use, but which quickly palls
when set before one every day; and we seem to have no other tins
left. There is no help for it—we must put up with the turnips; but I
am certain that, once I am home again, I shall not touch them for ten
years to come.
Amid all these minor evils, which, after all, go to make up the
genuine flavour of Africa, there is at least one cheering touch:
Knudsen has, with the dexterity of a skilled mechanic, repaired my 9
× 12 cm. camera, at least so far that I can use it with a little care.
How, in the absence of finger-nails, he was able to accomplish such a
ticklish piece of work, having no tool but a clumsy screw-driver for
taking to pieces and putting together again the complicated
mechanism of the instantaneous shutter, is still a mystery to me; but
he did it successfully. The loss of his finger-nails shows him in a light
contrasting curiously enough with the intelligence evinced by the
above operation; though, after all, it is scarcely surprising after his
ten years’ residence in the bush. One day, at Lindi, he had occasion
to wash a dog, which must have been in need of very thorough
cleansing, for the bottle handed to our friend for the purpose had an
extremely strong smell. Having performed his task in the most
conscientious manner, he perceived with some surprise that the dog
did not appear much the better for it, and was further surprised by
finding his own nails ulcerating away in the course of the next few
days. “How was I to know that carbolic acid has to be diluted?” he
mutters indignantly, from time to time, with a troubled gaze at his
mutilated finger-tips.
 Since we came to Newala we have been making excursions in all
directions through the surrounding country, in accordance with old
habit, and also because the akida Sefu did not get together the tribal
elders from whom I wanted information so speedily as he had
promised. There is, however, no harm done, as, even if seen only
from the outside, the country and people are interesting enough.
The Makonde plateau is like a large rectangular table rounded off
at the corners. Measured from the Indian Ocean to Newala, it is
about seventy-five miles long, and between the Rovuma and the
Lukuledi it averages fifty miles in breadth, so that its superficial area
is about two-thirds of that of the kingdom of Saxony. The surface,
however, is not level, but uniformly inclined from its south-western
edge to the ocean. From the upper edge, on which Newala lies, the
eye ranges for many miles east and north-east, without encountering
any obstacle, over the Makonde bush. It is a green sea, from which
here and there thick clouds of smoke rise, to show that it, too, is
inhabited by men who carry on their tillage like so many other
primitive peoples, by cutting down and burning the bush, and
manuring with the ashes. Even in the radiant light of a tropical day
such a fire is a grand sight.
Much less effective is the impression produced just now by the
great western plain as seen from the edge of the plateau. As often as
time permits, I stroll along this edge, sometimes in one direction,
sometimes in another, in the hope of finding the air clear enough to
let me enjoy the view; but I have always been disappointed.
Wherever one looks, clouds of smoke rise from the burning bush,
and the air is full of smoke and vapour. It is a pity, for under more
favourable circumstances the panorama of the whole country up to
the distant Majeje hills must be truly magnificent. It is of little use
taking photographs now, and an outline sketch gives a very poor idea
of the scenery. In one of these excursions I went out of my way to
make a personal attempt on the Makonde bush. The present edge of
the plateau is the result of a far-reaching process of destruction
through erosion and denudation. The Makonde strata are
everywhere cut into by ravines, which, though short, are hundreds of
yards in depth. In consequence of the loose stratification of these
beds, not only are the walls of these ravines nearly vertical, but their
upper end is closed by an equally steep escarpment, so that the
western edge of the Makonde plateau is hemmed in by a series of
deep, basin-like valleys. In order to get from one side of such a ravine
to the other, I cut my way through the bush with a dozen of my men.
It was a very open part, with more grass than scrub, but even so the
short stretch of less than two hundred yards was very hard work; at
the end of it the men’s calicoes were in rags and they themselves
bleeding from hundreds of scratches, while even our strong khaki
suits had not escaped scatheless.

NATIVE PATH THROUGH THE MAKONDE BUSH, NEAR

MAHUTA

I see increasing reason to believe that the view formed some time
back as to the origin of the Makonde bush is the correct one. I have
no doubt that it is not a natural product, but the result of human
occupation. Those parts of the high country where man—as a very
slight amount of practice enables the eye to perceive at once—has not
yet penetrated with axe and hoe, are still occupied by a splendid
timber forest quite able to sustain a comparison with our mixed
forests in Germany. But wherever man has once built his hut or tilled
his field, this horrible bush springs up. Every phase of this process
may be seen in the course of a couple of hours’ walk along the main
road. From the bush to right or left, one hears the sound of the axe—
not from one spot only, but from several directions at once. A few
steps further on, we can see what is taking place. The brush has been
cut down and piled up in heaps to the height of a yard or more,
between which the trunks of the large trees stand up like the last
pillars of a magnificent ruined building. These, too, present a
melancholy spectacle: the destructive Makonde have ringed them—
cut a broad strip of bark all round to ensure their dying off—and also
piled up pyramids of brush round them. Father and son, mother and
son-in-law, are chopping away perseveringly in the background—too
busy, almost, to look round at the white stranger, who usually excites
so much interest. If you pass by the same place a week later, the piles
of brushwood have disappeared and a thick layer of ashes has taken
the place of the green forest. The large trees stretch their
smouldering trunks and branches in dumb accusation to heaven—if
they have not already fallen and been more or less reduced to ashes,
perhaps only showing as a white stripe on the dark ground.
This work of destruction is carried out by the Makonde alike on the
virgin forest and on the bush which has sprung up on sites already
cultivated and deserted. In the second case they are saved the trouble
of burning the large trees, these being entirely absent in the
secondary bush.
After burning this piece of forest ground and loosening it with the
hoe, the native sows his corn and plants his vegetables. All over the
country, he goes in for bed-culture, which requires, and, in fact,
receives, the most careful attention. Weeds are nowhere tolerated in
the south of German East Africa. The crops may fail on the plains,
where droughts are frequent, but never on the plateau with its
abundant rains and heavy dews. Its fortunate inhabitants even have
the satisfaction of seeing the proud Wayao and Wamakua working
for them as labourers, driven by hunger to serve where they were
accustomed to rule.
But the light, sandy soil is soon exhausted, and would yield no
harvest the second year if cultivated twice running. This fact has
been familiar to the native for ages; consequently he provides in
time, and, while his crop is growing, prepares the next plot with axe
and firebrand. Next year he plants this with his various crops and
lets the first piece lie fallow. For a short time it remains waste and
desolate; then nature steps in to repair the destruction wrought by
man; a thousand new growths spring out of the exhausted soil, and
even the old stumps put forth fresh shoots. Next year the new growth
is up to one’s knees, and in a few years more it is that terrible,
impenetrable bush, which maintains its position till the black
occupier of the land has made the round of all the available sites and
come back to his starting point.
The Makonde are, body and soul, so to speak, one with this bush.
According to my Yao informants, indeed, their name means nothing
else but “bush people.” Their own tradition says that they have been
settled up here for a very long time, but to my surprise they laid great
stress on an original immigration. Their old homes were in the
south-east, near Mikindani and the mouth of the Rovuma, whence
their peaceful forefathers were driven by the continual raids of the
Sakalavas from Madagascar and the warlike Shirazis[47] of the coast,
to take refuge on the almost inaccessible plateau. I have studied
African ethnology for twenty years, but the fact that changes of
population in this apparently quiet and peaceable corner of the earth
could have been occasioned by outside enterprises taking place on
the high seas, was completely new to me. It is, no doubt, however,
correct.
The charming tribal legend of the Makonde—besides informing us
of other interesting matters—explains why they have to live in the
thickest of the bush and a long way from the edge of the plateau,
instead of making their permanent homes beside the purling brooks
and springs of the low country.
“The place where the tribe originated is Mahuta, on the southern
side of the plateau towards the Rovuma, where of old time there was
nothing but thick bush. Out of this bush came a man who never
washed himself or shaved his head, and who ate and drank but little.
He went out and made a human figure from the wood of a tree
growing in the open country, which he took home to his abode in the
bush and there set it upright. In the night this image came to life and
was a woman. The man and woman went down together to the
Rovuma to wash themselves. Here the woman gave birth to a still-
born child. They left that place and passed over the high land into the
valley of the Mbemkuru, where the woman had another child, which
was also born dead. Then they returned to the high bush country of
Mahuta, where the third child was born, which lived and grew up. In
course of time, the couple had many more children, and called
themselves Wamatanda. These were the ancestral stock of the
Makonde, also called Wamakonde,[48] i.e., aborigines. Their
forefather, the man from the bush, gave his children the command to
bury their dead upright, in memory of the mother of their race who
was cut out of wood and awoke to life when standing upright. He also
warned them against settling in the valleys and near large streams,
for sickness and death dwelt there. They were to make it a rule to
have their huts at least an hour’s walk from the nearest watering-
place; then their children would thrive and escape illness.”
The explanation of the name Makonde given by my informants is
somewhat different from that contained in the above legend, which I
extract from a little book (small, but packed with information), by
Pater Adams, entitled Lindi und sein Hinterland. Otherwise, my
results agree exactly with the statements of the legend. Washing?
Hapana—there is no such thing. Why should they do so? As it is, the
supply of water scarcely suffices for cooking and drinking; other
people do not wash, so why should the Makonde distinguish himself
by such needless eccentricity? As for shaving the head, the short,
woolly crop scarcely needs it,[49] so the second ancestral precept is
likewise easy enough to follow. Beyond this, however, there is
nothing ridiculous in the ancestor’s advice. I have obtained from
various local artists a fairly large number of figures carved in wood,
ranging from fifteen to twenty-three inches in height, and
representing women belonging to the great group of the Mavia,
Makonde, and Matambwe tribes. The carving is remarkably well
done and renders the female type with great accuracy, especially the
keloid ornamentation, to be described later on. As to the object and
meaning of their works the sculptors either could or (more probably)
would tell me nothing, and I was forced to content myself with the
scanty information vouchsafed by one man, who said that the figures
were merely intended to represent the nembo—the artificial
deformations of pelele, ear-discs, and keloids. The legend recorded
by Pater Adams places these figures in a new light. They must surely
be more than mere dolls; and we may even venture to assume that
they are—though the majority of present-day Makonde are probably
unaware of the fact—representations of the tribal ancestress.
 The references in the legend to the descent from Mahuta to the
Rovuma, and to a journey across the highlands into the Mbekuru
valley, undoubtedly indicate the previous history of the tribe, the
travels of the ancestral pair typifying the migrations of their
descendants. The descent to the neighbouring Rovuma valley, with
its extraordinary fertility and great abundance of game, is intelligible
at a glance—but the crossing of the Lukuledi depression, the ascent
to the Rondo Plateau and the descent to the Mbemkuru, also lie
within the bounds of probability, for all these districts have exactly
the same character as the extreme south. Now, however, comes a
point of especial interest for our bacteriological age. The primitive
Makonde did not enjoy their lives in the marshy river-valleys.
Disease raged among them, and many died. It was only after they
had returned to their original home near Mahuta, that the health
conditions of these people improved. We are very apt to think of the
African as a stupid person whose ignorance of nature is only equalled
by his fear of it, and who looks on all mishaps as caused by evil
spirits and malignant natural powers. It is much more correct to
assume in this case that the people very early learnt to distinguish
districts infested with malaria from those where it is absent.
This knowledge is crystallized in the
ancestral warning against settling in the
valleys and near the great waters, the
dwelling-places of disease and death. At the
same time, for security against the hostile
Mavia south of the Rovuma, it was enacted
that every settlement must be not less than a
certain distance from the southern edge of the
plateau. Such in fact is their mode of life at the
present day. It is not such a bad one, and
certainly they are both safer and more
comfortable than the Makua, the recent
intruders from the south, who have made USUAL METHOD OF
good their footing on the western edge of the CLOSING HUT-DOOR
plateau, extending over a fairly wide belt of
country. Neither Makua nor Makonde show in their dwellings
anything of the size and comeliness of the Yao houses in the plain,
especially at Masasi, Chingulungulu and Zuza’s. Jumbe Chauro, a
Makonde hamlet not far from Newala, on the road to Mahuta, is the
most important settlement of the tribe I have yet seen, and has fairly
spacious huts. But how slovenly is their construction compared with
the palatial residences of the elephant-hunters living in the plain.
The roofs are still more untidy than in the general run of huts during
the dry season, the walls show here and there the scanty beginnings
or the lamentable remains of the mud plastering, and the interior is a
veritable dog-kennel; dirt, dust and disorder everywhere. A few huts
only show any attempt at division into rooms, and this consists
merely of very roughly-made bamboo partitions. In one point alone
have I noticed any indication of progress—in the method of fastening
the door. Houses all over the south are secured in a simple but
ingenious manner. The door consists of a set of stout pieces of wood
or bamboo, tied with bark-string to two cross-pieces, and moving in
two grooves round one of the door-posts, so as to open inwards. If
the owner wishes to leave home, he takes two logs as thick as a man’s
upper arm and about a yard long. One of these is placed obliquely
against the middle of the door from the inside, so as to form an angle
of from 60° to 75° with the ground. He then places the second piece
horizontally across the first, pressing it downward with all his might.
It is kept in place by two strong posts planted in the ground a few
inches inside the door. This fastening is absolutely safe, but of course
cannot be applied to both doors at once, otherwise how could the
owner leave or enter his house? I have not yet succeeded in finding
out how the back door is fastened.

MAKONDE LOCK AND KEY AT JUMBE CHAURO

 This is the general way of closing a house. The Makonde at Jumbe
Chauro, however, have a much more complicated, solid and original
one. Here, too, the door is as already described, except that there is
only one post on the inside, standing by itself about six inches from
one side of the doorway. Opposite this post is a hole in the wall just
large enough to admit a man’s arm. The door is closed inside by a
large wooden bolt passing through a hole in this post and pressing
with its free end against the door. The other end has three holes into
which fit three pegs running in vertical grooves inside the post. The
door is opened with a wooden key about a foot long, somewhat
curved and sloped off at the butt; the other end has three pegs
corresponding to the holes, in the bolt, so that, when it is thrust
through the hole in the wall and inserted into the rectangular
opening in the post, the pegs can be lifted and the bolt drawn out.[50]

MODE OF INSERTING THE KEY

With no small pride first one householder and then a second

showed me on the spot the action of this greatest invention of the
Makonde Highlands. To both with an admiring exclamation of
“Vizuri sana!” (“Very fine!”). I expressed the wish to take back these
marvels with me to Ulaya, to show the Wazungu what clever fellows
the Makonde are. Scarcely five minutes after my return to camp at
Newala, the two men came up sweating under the weight of two
heavy logs which they laid down at my feet, handing over at the same
time the keys of the fallen fortress. Arguing, logically enough, that if
the key was wanted, the lock would be wanted with it, they had taken
their axes and chopped down the posts—as it never occurred to them
to dig them out of the ground and so bring them intact. Thus I have
two badly damaged specimens, and the owners, instead of praise,
come in for a blowing-up.
The Makua huts in the environs of Newala are especially
miserable; their more than slovenly construction reminds one of the
temporary erections of the Makua at Hatia’s, though the people here
have not been concerned in a war. It must therefore be due to
congenital idleness, or else to the absence of a powerful chief. Even
the baraza at Mlipa’s, a short hour’s walk south-east of Newala,
shares in this general neglect. While public buildings in this country
are usually looked after more or less carefully, this is in evident
danger of being blown over by the first strong easterly gale. The only
attractive object in this whole district is the grave of the late chief
Mlipa. I visited it in the morning, while the sun was still trying with
partial success to break through the rolling mists, and the circular
grove of tall euphorbias, which, with a broken pot, is all that marks
the old king’s resting-place, impressed one with a touch of pathos.
Even my very materially-minded carriers seemed to feel something
of the sort, for instead of their usual ribald songs, they chanted
solemnly, as we marched on through the dense green of the Makonde
bush:—
 “We shall arrive with the great master; we stand in a row and have
no fear about getting our food and our money from the Serkali (the
Government). We are not afraid; we are going along with the great
master, the lion; we are going down to the coast and back.”
With regard to the characteristic features of the various tribes here
on the western edge of the plateau, I can arrive at no other
conclusion than the one already come to in the plain, viz., that it is
impossible for anyone but a trained anthropologist to assign any
given individual at once to his proper tribe. In fact, I think that even
an anthropological specialist, after the most careful examination,
might find it a difficult task to decide. The whole congeries of peoples
collected in the region bounded on the west by the great Central
African rift, Tanganyika and Nyasa, and on the east by the Indian
Ocean, are closely related to each other—some of their languages are
only distinguished from one another as dialects of the same speech,
and no doubt all the tribes present the same shape of skull and
structure of skeleton. Thus, surely, there can be no very striking
differences in outward appearance.
 Even did such exist, I should have no time
to concern myself with them, for day after day,
I have to see or hear, as the case may be—in
any case to grasp and record—an
extraordinary number of ethnographic
phenomena. I am almost disposed to think it
fortunate that some departments of inquiry, at
least, are barred by external circumstances.
Chief among these is the subject of iron-
working. We are apt to think of Africa as a
country where iron ore is everywhere, so to
speak, to be picked up by the roadside, and
where it would be quite surprising if the
inhabitants had not learnt to smelt the
material ready to their hand. In fact, the
knowledge of this art ranges all over the
continent, from the Kabyles in the north to the
Kafirs in the south. Here between the Rovuma
and the Lukuledi the conditions are not so
favourable. According to the statements of the
Makonde, neither ironstone nor any other
form of iron ore is known to them. They have
not therefore advanced to the art of smelting
the metal, but have hitherto bought all their
THE ANCESTRESS OF
THE MAKONDE
iron implements from neighbouring tribes.
Even in the plain the inhabitants are not much
better off. Only one man now living is said to
understand the art of smelting iron. This old fundi lives close to
Huwe, that isolated, steep-sided block of granite which rises out of
the green solitude between Masasi and Chingulungulu, and whose
jagged and splintered top meets the traveller’s eye everywhere. While
still at Masasi I wished to see this man at work, but was told that,
frightened by the rising, he had retired across the Rovuma, though
he would soon return. All subsequent inquiries as to whether the
fundi had come back met with the genuine African answer, “Bado”
(“Not yet”).
 BRAZIER

Some consolation was afforded me by a brassfounder, whom I

came across in the bush near Akundonde’s. This man is the favourite
of women, and therefore no doubt of the gods; he welds the glittering
brass rods purchased at the coast into those massive, heavy rings
which, on the wrists and ankles of the local fair ones, continually give
me fresh food for admiration. Like every decent master-craftsman he
had all his tools with him, consisting of a pair of bellows, three
crucibles and a hammer—nothing more, apparently. He was quite
willing to show his skill, and in a twinkling had fixed his bellows on
the ground. They are simply two goat-skins, taken off whole, the four
legs being closed by knots, while the upper opening, intended to
admit the air, is kept stretched by two pieces of wood. At the lower
end of the skin a smaller opening is left into which a wooden tube is
stuck. The fundi has quickly borrowed a heap of wood-embers from
the nearest hut; he then fixes the free ends of the two tubes into an
earthen pipe, and clamps them to the ground by means of a bent
piece of wood. Now he fills one of his small clay crucibles, the dross
on which shows that they have been long in use, with the yellow
material, places it in the midst of the embers, which, at present are
only faintly glimmering, and begins his work. In quick alternation
the smith’s two hands move up and down with the open ends of the
bellows; as he raises his hand he holds the slit wide open, so as to let
the air enter the skin bag unhindered. In pressing it down he closes
the bag, and the air puffs through the bamboo tube and clay pipe into
the fire, which quickly burns up. The smith, however, does not keep
on with this work, but beckons to another man, who relieves him at
the bellows, while he takes some more tools out of a large skin pouch
carried on his back. I look on in wonder as, with a smooth round
stick about the thickness of a finger, he bores a few vertical holes into
the clean sand of the soil. This should not be difficult, yet the man
seems to be taking great pains over it. Then he fastens down to the
ground, with a couple of wooden clamps, a neat little trough made by
splitting a joint of bamboo in half, so that the ends are closed by the
two knots. At last the yellow metal has attained the right consistency,
and the fundi lifts the crucible from the fire by means of two sticks
split at the end to serve as tongs. A short swift turn to the left—a
tilting of the crucible—and the molten brass, hissing and giving forth
clouds of smoke, flows first into the bamboo mould and then into the
holes in the ground.
The technique of this backwoods craftsman may not be very far
advanced, but it cannot be denied that he knows how to obtain an
adequate result by the simplest means. The ladies of highest rank in
this country—that is to say, those who can afford it, wear two kinds
of these massive brass rings, one cylindrical, the other semicircular
in section. The latter are cast in the most ingenious way in the
bamboo mould, the former in the circular hole in the sand. It is quite
a simple matter for the fundi to fit these bars to the limbs of his fair
customers; with a few light strokes of his hammer he bends the
pliable brass round arm or ankle without further inconvenience to
the wearer.
SHAPING THE POT

SMOOTHING WITH MAIZE-COB

CUTTING THE EDGE

 FINISHING THE BOTTOM

LAST SMOOTHING BEFORE

BURNING

FIRING THE BRUSH-PILE

 LIGHTING THE FARTHER SIDE OF
THE PILE

TURNING THE RED-HOT VESSEL

NYASA WOMAN MAKING POTS AT MASASI

Pottery is an art which must always and everywhere excite the
interest of the student, just because it is so intimately connected with
the development of human culture, and because its relics are one of
the principal factors in the reconstruction of our own condition in
prehistoric times. I shall always remember with pleasure the two or
three afternoons at Masasi when Salim Matola’s mother, a slightly-
built, graceful, pleasant-looking woman, explained to me with
touching patience, by means of concrete illustrations, the ceramic art
of her people. The only implements for this primitive process were a
lump of clay in her left hand, and in the right a calabash containing
the following valuables: the fragment of a maize-cob stripped of all
its grains, a smooth, oval pebble, about the size of a pigeon’s egg, a
few chips of gourd-shell, a bamboo splinter about the length of one’s
hand, a small shell, and a bunch of some herb resembling spinach.
 Nothing more. The woman scraped with the
shell a round, shallow hole in the soft, fine
sand of the soil, and, when an active young
girl had filled the calabash with water for her,
she began to knead the clay. As if by magic it
gradually assumed the shape of a rough but
already well-shaped vessel, which only wanted
a little touching up with the instruments
before mentioned. I looked out with the
MAKUA WOMAN closest attention for any indication of the use
MAKING A POT. of the potter’s wheel, in however rudimentary
SHOWS THE a form, but no—hapana (there is none). The
BEGINNINGS OF THE embryo pot stood firmly in its little
POTTER’S WHEEL
depression, and the woman walked round it in
a stooping posture, whether she was removing
small stones or similar foreign bodies with the maize-cob, smoothing
the inner or outer surface with the splinter of bamboo, or later, after
letting it dry for a day, pricking in the ornamentation with a pointed
bit of gourd-shell, or working out the bottom, or cutting the edge
with a sharp bamboo knife, or giving the last touches to the finished
vessel. This occupation of the women is infinitely toilsome, but it is
without doubt an accurate reproduction of the process in use among
our ancestors of the Neolithic and Bronze ages.
There is no doubt that the invention of pottery, an item in human
progress whose importance cannot be over-estimated, is due to
women. Rough, coarse and unfeeling, the men of the horde range
over the countryside. When the united cunning of the hunters has
succeeded in killing the game; not one of them thinks of carrying
home the spoil. A bright fire, kindled by a vigorous wielding of the
drill, is crackling beside them; the animal has been cleaned and cut
up secundum artem, and, after a slight singeing, will soon disappear
under their sharp teeth; no one all this time giving a single thought
to wife or child.
To what shifts, on the other hand, the primitive wife, and still more
the primitive mother, was put! Not even prehistoric stomachs could
endure an unvarying diet of raw food. Something or other suggested
the beneficial effect of hot water on the majority of approved but
indigestible dishes. Perhaps a neighbour had tried holding the hard
roots or tubers over the fire in a calabash filled with water—or maybe
an ostrich-egg-shell, or a hastily improvised vessel of bark. They
became much softer and more palatable than they had previously
been; but, unfortunately, the vessel could not stand the fire and got
charred on the outside. That can be remedied, thought our
ancestress, and plastered a layer of wet clay round a similar vessel.
This is an improvement; the cooking utensil remains uninjured, but
the heat of the fire has shrunk it, so that it is loose in its shell. The
next step is to detach it, so, with a firm grip and a jerk, shell and
kernel are separated, and pottery is invented. Perhaps, however, the
discovery which led to an intelligent use of the burnt-clay shell, was
made in a slightly different way. Ostrich-eggs and calabashes are not
to be found in every part of the world, but everywhere mankind has
arrived at the art of making baskets out of pliant materials, such as
bark, bast, strips of palm-leaf, supple twigs, etc. Our inventor has no
water-tight vessel provided by nature. “Never mind, let us line the
basket with clay.” This answers the purpose, but alas! the basket gets
burnt over the blazing fire, the woman watches the process of
cooking with increasing uneasiness, fearing a leak, but no leak
appears. The food, done to a turn, is eaten with peculiar relish; and
the cooking-vessel is examined, half in curiosity, half in satisfaction
at the result. The plastic clay is now hard as stone, and at the same
time looks exceedingly well, for the neat plaiting of the burnt basket
is traced all over it in a pretty pattern. Thus, simultaneously with
pottery, its ornamentation was invented.
Primitive woman has another claim to respect. It was the man,
roving abroad, who invented the art of producing fire at will, but the
woman, unable to imitate him in this, has been a Vestal from the
earliest times. Nothing gives so much trouble as the keeping alight of
the smouldering brand, and, above all, when all the men are absent
from the camp. Heavy rain-clouds gather, already the first large
drops are falling, the first gusts of the storm rage over the plain. The
little flame, a greater anxiety to the woman than her own children,
flickers unsteadily in the blast. What is to be done? A sudden thought
occurs to her, and in an instant she has constructed a primitive hut
out of strips of bark, to protect the flame against rain and wind.
This, or something very like it, was the way in which the principle
of the house was discovered; and even the most hardened misogynist
cannot fairly refuse a woman the credit of it. The protection of the
hearth-fire from the weather is the germ from which the human
dwelling was evolved. Men had little, if any share, in this forward
step, and that only at a late stage. Even at the present day, the
plastering of the housewall with clay and the manufacture of pottery
are exclusively the women’s business. These are two very significant
survivals. Our European kitchen-garden, too, is originally a woman’s
invention, and the hoe, the primitive instrument of agriculture, is,
characteristically enough, still used in this department. But the
noblest achievement which we owe to the other sex is unquestionably
the art of cookery. Roasting alone—the oldest process—is one for
which men took the hint (a very obvious one) from nature. It must
have been suggested by the scorched carcase of some animal
overtaken by the destructive forest-fires. But boiling—the process of
improving organic substances by the help of water heated to boiling-
point—is a much later discovery. It is so recent that it has not even
yet penetrated to all parts of the world. The Polynesians understand
how to steam food, that is, to cook it, neatly wrapped in leaves, in a
hole in the earth between hot stones, the air being excluded, and
(sometimes) a few drops of water sprinkled on the stones; but they
do not understand boiling.
To come back from this digression, we find that the slender Nyasa
woman has, after once more carefully examining the finished pot,
put it aside in the shade to dry. On the following day she sends me
word by her son, Salim Matola, who is always on hand, that she is
going to do the burning, and, on coming out of my house, I find her
already hard at work. She has spread on the ground a layer of very
dry sticks, about as thick as one’s thumb, has laid the pot (now of a
yellowish-grey colour) on them, and is piling brushwood round it.
My faithful Pesa mbili, the mnyampara, who has been standing by,
most obligingly, with a lighted stick, now hands it to her. Both of
them, blowing steadily, light the pile on the lee side, and, when the
flame begins to catch, on the weather side also. Soon the whole is in a
blaze, but the dry fuel is quickly consumed and the fire dies down, so
that we see the red-hot vessel rising from the ashes. The woman
turns it continually with a long stick, sometimes one way and
sometimes another, so that it may be evenly heated all over. In
twenty minutes she rolls it out of the ash-heap, takes up the bundle
of spinach, which has been lying for two days in a jar of water, and
sprinkles the red-hot clay with it. The places where the drops fall are
marked by black spots on the uniform reddish-brown surface. With a
sigh of relief, and with visible satisfaction, the woman rises to an
erect position; she is standing just in a line between me and the fire,
from which a cloud of smoke is just rising: I press the ball of my
camera, the shutter clicks—the apotheosis is achieved! Like a
priestess, representative of her inventive sex, the graceful woman
stands: at her feet the hearth-fire she has given us beside her the
invention she has devised for us, in the background the home she has
built for us.
At Newala, also, I have had the manufacture of pottery carried on
in my presence. Technically the process is better than that already
described, for here we find the beginnings of the potter’s wheel,
which does not seem to exist in the plains; at least I have seen
nothing of the sort. The artist, a frightfully stupid Makua woman, did
not make a depression in the ground to receive the pot she was about
to shape, but used instead a large potsherd. Otherwise, she went to
work in much the same way as Salim’s mother, except that she saved
herself the trouble of walking round and round her work by squatting
at her ease and letting the pot and potsherd rotate round her; this is
surely the first step towards a machine. But it does not follow that
the pot was improved by the process. It is true that it was beautifully
rounded and presented a very creditable appearance when finished,
but the numerous large and small vessels which I have seen, and, in
part, collected, in the “less advanced” districts, are no less so. We
moderns imagine that instruments of precision are necessary to
produce excellent results. Go to the prehistoric collections of our
museums and look at the pots, urns and bowls of our ancestors in the
dim ages of the past, and you will at once perceive your error.
MAKING LONGITUDINAL CUT IN
BARK

DRAWING THE BARK OFF THE LOG

REMOVING THE OUTER BARK

 BEATING THE BARK

WORKING THE BARK-CLOTH AFTER BEATING, TO MAKE IT

SOFT

MANUFACTURE OF BARK-CLOTH AT NEWALA

To-day, nearly the whole population of German East Africa is
clothed in imported calico. This was not always the case; even now in
some parts of the north dressed skins are still the prevailing wear,
and in the north-western districts—east and north of Lake
Tanganyika—lies a zone where bark-cloth has not yet been
superseded. Probably not many generations have passed since such
bark fabrics and kilts of skins were the only clothing even in the
south. Even to-day, large quantities of this bright-red or drab
material are still to be found; but if we wish to see it, we must look in
the granaries and on the drying stages inside the native huts, where
it serves less ambitious uses as wrappings for those seeds and fruits
which require to be packed with special care. The salt produced at
Masasi, too, is packed for transport to a distance in large sheets of
bark-cloth. Wherever I found it in any degree possible, I studied the
process of making this cloth. The native requisitioned for the
purpose arrived, carrying a log between two and three yards long and
as thick as his thigh, and nothing else except a curiously-shaped
mallet and the usual long, sharp and pointed knife which all men and
boys wear in a belt at their backs without a sheath—horribile dictu!
[51]
Silently he squats down before me, and with two rapid cuts has
drawn a couple of circles round the log some two yards apart, and
slits the bark lengthwise between them with the point of his knife.
With evident care, he then scrapes off the outer rind all round the
log, so that in a quarter of an hour the inner red layer of the bark
shows up brightly-coloured between the two untouched ends. With
some trouble and much caution, he now loosens the bark at one end,
and opens the cylinder. He then stands up, takes hold of the free
edge with both hands, and turning it inside out, slowly but steadily
pulls it off in one piece. Now comes the troublesome work of
scraping all superfluous particles of outer bark from the outside of
the long, narrow piece of material, while the inner side is carefully
scrutinised for defective spots. At last it is ready for beating. Having
signalled to a friend, who immediately places a bowl of water beside
him, the artificer damps his sheet of bark all over, seizes his mallet,
lays one end of the stuff on the smoothest spot of the log, and
hammers away slowly but continuously. “Very simple!” I think to
myself. “Why, I could do that, too!”—but I am forced to change my
opinions a little later on; for the beating is quite an art, if the fabric is
not to be beaten to pieces. To prevent the breaking of the fibres, the
stuff is several times folded across, so as to interpose several
thicknesses between the mallet and the block. At last the required
state is reached, and the fundi seizes the sheet, still folded, by both
ends, and wrings it out, or calls an assistant to take one end while he
holds the other. The cloth produced in this way is not nearly so fine
and uniform in texture as the famous Uganda bark-cloth, but it is
quite soft, and, above all, cheap.
Now, too, I examine the mallet. My craftsman has been using the
simpler but better form of this implement, a conical block of some
hard wood, its base—the striking surface—being scored across and
across with more or less deeply-cut grooves, and the handle stuck
into a hole in the middle. The other and earlier form of mallet is
shaped in the same way, but the head is fastened by an ingenious
network of bark strips into the split bamboo serving as a handle. The
observation so often made, that ancient customs persist longest in
connection with religious ceremonies and in the life of children, here
finds confirmation. As we shall soon see, bark-cloth is still worn
during the unyago,[52] having been prepared with special solemn
ceremonies; and many a mother, if she has no other garment handy,
will still put her little one into a kilt of bark-cloth, which, after all,
looks better, besides being more in keeping with its African
surroundings, than the ridiculous bit of print from Ulaya.
MAKUA WOMEN