PREVIEW Banking is not the only type of financial intermediation you are likely to experience. You might decide to purchase insurance, take out an installment loan from a finance company, or buy a share of stock. In each of these transactions you will be engaged in nonbank finance and will deal with nonbank financial institutions. In our economy, nonbank finance also plays an important role in channeling funds from lender-savers to borrower-spenders. Furthermore, the process of financial innovation we discussed in Chapter 10 has increased the importance of nonbank finance and is blurring the distinction between different financial institutons. This chapter examines in more detail how institutions engaged in nonbank finance operate, how they are regulated, and recent trends in nonbank finance. Insurance Every day we face the possibility of the occurrence of certain catastrophic events that could lead to large financial losses. A spouse’s earnings might disappear due to death or illness; a car accident might result in costly repair bills or payments to an injured party. Because financial losses from crises could be large relative to our financial resources, we protect ourselves against them by purchasing insurance coverage that will pay a sum of money if catastrophic events occur. Life insurance companies sell policies that provide income if a person dies, is incapacitated by illness, or retires. Property and casualty companies specialize in policies that pay for losses incurred as a result of accidents, fire, or theft. The first life insurance company in the United States (Presbyterian Ministers’ Fund in Philadelphia) was established in 1759 and is still in existence. There are currently about 1,400 life insurance companies, which are organized in two forms: as stock companies or as mutuals. Stock companies are owned by stockholders; mutuals are technically owned by the policyholders. Although over 90% of life insurance compa- nies are organized as stock companies, some of the largest ones are organized as mutuals. Unlike commercial banks and other depository institutions, life insurance com- panies have never experienced widespread failures, so the federal government has not seen the need to regulate the industry. Instead, regulation is left to the states in which a company operates. State regulation is directed at sales practices, the provision of Life Insurance 287 Chapter Nonbank Finance 12 www.iii.org The Insurance Information Institute publishes facts and statistics about the insurance industry. adequate liquid assets to cover losses, and restrictions on the amount of risky assets (such as common stock) that the companies can hold. The regulatory authority is typ- ically a state insurance commissioner. Because death rates for the population as a whole are predictable with a high degree of certainty, life insurance companies can accurately predict what their payouts to policyholders will be in the future. Consequently, they hold long-term assets that are not particularly liquid—corporate bonds and commercial mortgages as well as some corporate stock. There are two principal forms of life insurance policies: permanent life insurance (such as whole, universal, and variable life) and temporary insurance (such as term). Permanent life insurance policies have a constant premium throughout the life of the policy. In the early years of the policy, the size of this premium exceeds the amount needed to insure against death because the probability of death is low. Thus the pol- icy builds up a cash value in its early years, but in later years the cash value declines because the constant premium falls below the amount needed to insure against death, the probability of which is now higher. The policyholder can borrow against the cash value of the permanent life policy or can claim it by canceling the policy. Term insurance, by contrast, has a premium that is matched every year to the amount needed to insure against death during the period of the term (such as one year or five years). As a result, term policies have premiums that rise over time as the probability of death rises (or level premiums with a decline in the amount of death benefits). Term policies have no cash value and thus, in contrast to permanent life policies, provide insurance only, with no savings aspect. Weak investment returns on permanent life insurance in the 1960s and 1970s led to slow growth of demand for life insurance products. The result was a shrinkage in the size of the life insurance industry relative to other financial intermediaries, with their share of total financial intermediary assets falling from 19.6% at the end of 1960 to 11.5% at the end of 1980. (See Table 1, which shows the relative shares of financial intermediary assets for each of the financial intermediaries discussed in this chapter.) Beginning in the mid-1970s, life insurance companies began to restructure their business to become managers of assets for pension funds. An important factor behind this restructuring was 1974 legislation that encouraged pension funds to turn fund management over to life insurance companies. Now more than half of the assets man- aged by life insurance companies are for pension funds and not for life insurance. Insurance companies have also begun to sell investment vehicles for retirement such as annuities, arrangements whereby the customer pays an annual premium in exchange for a future stream of annual payments beginning at a set age, say 65, and continuing until death. The result of this new business has been that the market share of life insurance companies as a percentage of total financial intermediary assets has held steady since 1980. There are on the order of 3,000 property and casualty insurance companies in the United States, the two largest of which are State Farm and Allstate. Property and casu- alty companies are organized as both stock and mutual companies and are regulated by the states in which they operate. Although property and casualty insurance companies had a slight increase in their share of total financial intermediary assets from 1960 to 1990 (see Table 1), in recent years they have not fared well, and insurance premiums have skyrocketed. With the high interest rates in the 1970s and 1980s, insurance companies had high Property and Casualty Insurance 288 PART III Financial Institutions www.federalreserve.gov /releases/Z1/ The Flow of Funds Accounts of the United States reports details about the current state of the insurance industry. Scroll down through the table of contents to find the location of data on insurance companies. investment income that enabled them to keep insurance rates low. Since then, how- ever, investment income has fallen with the decline in interest rates, while the growth in lawsuits involving property and casualty insurance and the explosion in amounts awarded in such cases have produced substantial losses for companies. To return to profitability, insurance companies have raised their rates dramati- cally—sometimes doubling or even tripling premiums—and have refused to provide coverage for some people. They have also campaigned actively for limits on insurance payouts, particularly for medical malpractice. In the search for profits, insurance com- panies are also branching out into uncharted territory by insuring the payment of interest on municipal and corporate bonds and on mortgage-backed securities. One worry is that the insurance companies may be taking on excessive risk in order to boost their profits. One result of the concern about the health of the property and casualty insurance industry is that insurance regulators have proposed new rules that would impose risk-based capital requirements on these companies based on the risk- iness of their assets and operations. The investment policies of these companies are affected by two basic facts. First, because they are subject to federal income taxes, the largest share of their assets is held in tax-exempt municipal bonds. Second, because property losses are more uncertain than the death rate in a population, these insurers are less able to predict how much they will have to pay policyholders than life insurance companies are. Natural or CHAPTER 12 Nonbank Finance 289 1960 1970 1980 1990 2002 Insurance Companies Life insurance 19.6 15.3 11.5 12.5 13.6 Property and casualty 4.4 3.8 4.5 4.9 3.7 Pension Funds Private 6.4 8.4 12.5 14.9 14.7 Public (state and local government) 3.3 4.6 4.9 6.7 7.9 Finance Companies 4.7 4.9 5.1 5.6 3.2 Mutual Funds Stock and bond 2.9 3.6 1.7 5.9 10.6 Money market 0.0 0.0 1.9 4.6 8.8 Depository Institutions (Banks) Commercial banks 38.6 38.5 36.7 30.4 29.8 S&L and mutual savings banks 19.0 19.4 19.6 12.5 5.6 Credit unions 1.1 1.4 1.6 2.0 2.3 Total 100.0 100.0 100.0 100.0 100.0 Source: Federal Reserve Flow of Funds Accounts. Table 1 Relative Shares of Total Financial Intermediary Assets, 1960–2002 (percent) unnatural disasters such as the Los Angeles earthquake in 1994 and Hurricane Floyd in 1999, which devastated parts of the East Coast, and the September 11, 2001 destruction of the World Trade Center, exposed the property and casualty insurance companies to billions of dollars of losses. Therefore, property and casualty insurance companies hold more liquid assets than life insurance companies; municipal bonds and U.S. government securities amount to over half their assets, and most of the remainder is held in corporate bonds and corporate stock. Property and casualty insurance companies will insure against losses from almost any type of event, including fire, theft, negligence, malpractice, earthquakes, and automobile accidents. If a possible loss being insured is too large for any one firm, several firms may join together to write a policy in order to share the risk. Insurance companies may also reduce their risk exposure by obtaining reinsurance. Reinsurance allocates a portion of the risk to another company in exchange for a portion of the premium and is particularly important for small insurance companies. You can think of reinsurance as insurance for the insurance company. The most famous risk-sharing operation is Lloyd’s of London, an association in which different insurance companies can underwrite a fraction of an insurance policy. Lloyd’s of London has claimed that it will insure against any contingency—for a price. Until recently, banks have been restricted in their ability to sell life insurance prod- ucts. This has been changing rapidly, however. Over two-thirds of the states allow banks to sell life insurance in one form or another. In recent years, the bank regula- tory authorities, particularly the Office of the Comptroller of the Currency (OCC), have also encouraged banks to enter the insurance field because getting into insur- ance would help diversify banks’ business, thereby improving their economic health and making bank failures less likely. For example, in 1990, the OCC ruled that sell- ing annuities was a form of investment that was incidental to the banking business and so was a permissible banking activity. As a result, the banks’ share of the annu- ities market has surpassed 20%. Currently, more than 40% of banks sell insurance products, and the number is expected to grow in the future. Insurance companies and their agents reacted to this competitive threat with both lawsuits and lobbying actions to block banks from entering the insurance business. Their efforts were set back by several Supreme Court rulings that favored the banks. Particularly important was a ruling in favor of Barnett Bank in March 1996, which held that state laws to prevent banks from selling insurance can be superseded by federal rulings from banking regulators that allow banks to sell insurance. The decision gave banks a green light to further their insurance activities, and with the passage of the Gramm-Leach-Bliley Act of 1999, banking institutions will further engage in the insur- ance business, thus blurring the distinction between insurance companies and banks. The Competitive Threat from the Banking Industry 290 PART III Financial Institutions Insurance Management Application Insurance, like banking, is in the financial intermediation business of trans- forming one type of asset into another for the public. Insurance providers use the premiums paid on policies to invest in assets such as bonds, stocks, mortgages, and other loans; the earnings from these assets are then used to pay out claims on the policies. In effect, insurers transform assets such as CHAPTER 12 Nonbank Finance 291 bonds, stocks, and loans into insurance policies that provide a set of serv- ices (for example, claim adjustments, savings plans, friendly insurance agents). If the insurer’s production process of asset transformation efficiently provides its customers with adequate insurance services at low cost and if it can earn high returns on its investments, it will make profits; if not, it will suffer losses. In Chapter 9 the economic concepts of adverse selection and moral haz- ard allowed us to understand principles of bank management related to man- aging credit risk; many of these same principles also apply to the lending activities of insurers. Here again we apply the adverse selection and moral haz- ard concepts to explain many management practices specific to insurance. In the case of an insurance policy, moral hazard arises when the existence of insurance encourages the insured party to take risks that increase the like- lihood of an insurance payoff. For example, a person covered by burglary insurance might not take as many precautions to prevent a burglary because the insurance company will reimburse most of the losses if a theft occurs. Adverse selection holds that the people most likely to receive large insurance payoffs are the ones who will want to purchase insurance the most. For example, a person suffering from a terminal disease would want to take out the biggest life and medical insurance policies possible, thereby exposing the insurance company to potentially large losses. Both adverse selection and moral hazard can result in large losses to insurance companies, because they lead to higher payouts on insurance claims. Lowering adverse selection and moral hazard to reduce these payouts is therefore an extremely important goal for insurance companies, and this goal explains the insurance practices we will discuss here. To reduce adverse selection, insurance providers try to screen out good insur- ance risks from poor ones. Effective information collection procedures are therefore an important principle of insurance management. When you apply for auto insurance, the first thing your insurance agent does is ask you questions about your driving record (number of speeding tickets and accidents), the type of car you are insuring, and certain personal matters (age, marital status). If you are applying for life insurance, you go through a similar grilling, but you are asked even more personal questions about such things as your health, smoking habits, and drug and alcohol use. The life insurer even orders a medical evaluation (usually done by an inde- pendent company) that involves taking blood and urine samples. Just as a bank calculates a credit score to evaluate a potential borrower, the insurers use the information you provide to allocate you to a risk class—a statistical estimate of how likely you are to have an insurance claim. Based on this information, the insurer can decide whether to accept you for the insurance or to turn you down because you pose too high a risk and thus would be an unprofitable customer. Charging insurance premiums on the basis of how much risk a policyholder poses for the insurance provider is a time-honored principle of insurance management. Adverse selection explains why this principle is so important to insurance company profitability. Risk-Based Premiums Screening 292 PART III Financial Institutions To understand why an insurance provider finds it necessary to have risk- based premiums, let’s examine an example of risk-based insurance premiums that at first glance seems unfair. Harry and Sally, both college students with no accidents or speeding tickets, apply for auto insurance. Normally, Harry will be charged a much higher premium than Sally. Insurance providers do this because young males have a much higher accident rate than young females. Suppose, though, that one insurer did not base its premiums on a risk classi- fication but rather just charged a premium based on the average combined risk for males and females. Then Sally would be charged too much and Harry too little. Sally could go to another insurer and get a lower rate, while Harry would sign up for the insurance. Because Harry’s premium isn’t high enough to cover the accidents he is likely to have, on average the insurer would lose money on Harry. Only with a premium based on a risk classification, so that Harry is charged more, can the insurance provider make a profit. 1 Restrictive provisions in policies are an insurance management tool for reducing moral hazard. Such provisions discourage policyholders from engaging in risky activities that make an insurance claim more likely. For example, life insurers have provisions in their policies that eliminate death benefits if the insured person commits suicide within the first two years that the policy is in effect. Restrictive provisions may also require certain behav- ior on the part of the insured. A company renting motor scooters may be required to provide helmets for renters in order to be covered for any liabil- ity associated with the rental. The role of restrictive provisions is not unlike that of restrictive covenants on debt contracts described in Chapter 8: Both serve to reduce moral hazard by ruling out undesirable behavior. Insurance providers also face moral hazard because an insured person has an incentive to lie to the insurer and seek a claim even if the claim is not valid. For example, a person who has not complied with the restrictive provisions of an insurance contract may still submit a claim. Even worse, a person may file claims for events that did not actually occur. Thus an important manage- ment principle for insurance providers is conducting investigations to pre- vent fraud so that only policyholders with valid claims receive compensation. Being prepared to cancel policies is another insurance management tool. Insurers can discourage moral hazard by threatening to cancel a policy when the insured person engages in activities that make a claim more likely. If your auto insurance company makes it clear that coverage will be canceled if a driver gets too many speeding tickets, you will be less likely to speed. The deductible is the fixed amount by which the insured’s loss is reduced when a claim is paid off. A $250 deductible on an auto policy, for example, Deductibles Cancellation of Insurance Prevention of Fraud Restrictive Provisions 1 Note that the example here is in fact the lemons problem described in Chapter 8. CHAPTER 12 Nonbank Finance 293 means that if you suffer a loss of $1,000 because of an accident, the insurer will pay you only $750. Deductibles are an additional management tool that helps insurance providers reduce moral hazard. With a deductible, you expe- rience a loss along with the insurer when you make a claim. Because you also stand to lose when you have an accident, you have an incentive to drive more carefully. A deductible thus makes a policyholder act more in line with what is profitable for the insurer; moral hazard has been reduced. And because moral hazard has been reduced, the insurance provider can lower the pre- mium by more than enough to compensate the policyholder for the existence of the deductible. Another function of the deductible is to eliminate the administrative costs of handling small claims by forcing the insured to bear these losses. When a policyholder shares a percentage of the losses along with the insurer, their arrangement is called coinsurance. For example, some medical insur- ance plans provide coverage for 80% of medical bills, and the insured person pays 20% after a certain deductible has been met. Coinsurance works to reduce moral hazard in exactly the same way that a deductible does. A policy- holder who suffers a loss along with the insurer has less incentive to take actions, such as going to the doctor unnecessarily, that involve higher claims. Coinsurance is thus another useful management tool for insurance providers. Another important principle of insurance management is that there should be limits on the amount of insurance provided, even though a customer is willing to pay for more coverage. The higher the insurance coverage, the more the insured person can gain from risky activities that make an insur- ance payoff more likely and hence the greater the moral hazard. For exam- ple, if Zelda’s car were insured for more than its true value, she might not take proper precautions to prevent its theft, such as making sure that the key is always removed or putting in an alarm system. If it were stolen, she comes out ahead because the excessive insurance payment would allow her to buy an even better car. By contrast, when the insurance payments are lower than the value of her car, she will suffer a loss if it is stolen and will thus take precautions to prevent this from happening. Insurance providers must always make sure that their coverage is not so high that moral hazard leads to large losses. Effective insurance management requires several practices: information col- lection and screening of potential policyholders, risk-based premiums, restric- tive provisions, prevention of fraud, cancellation of insurance, deductibles, coinsurance, and limits on the amount of insurance. All of these practices reduce moral hazard and adverse selection by making it harder for policy- holders to benefit from engaging in activities that increase the amount and likelihood of claims. With smaller benefits available, the poor insurance risks (those who are more likely to engage in the activities in the first place) see less benefit from the insurance and are thus less likely to seek it out. Summary Limits on the Amount of Insurance Coinsurance Pension Funds In performing the financial intermediation function of asset transformation, pension funds provide the public with another kind of protection: income payments on retirement. Employers, unions, or private individuals can set up pension plans, which acquire funds through contributions paid in by the plan’s participants. As we can see in Table 1, pension plans both public and private have grown in importance, with their share of total financial intermediary assets rising from 10% at the end of 1960 to 22.6% at the end of 2002. Federal tax policy has been a major factor behind the rapid growth of pension funds because employer contributions to employee pen- sion plans are tax-deductible. Furthermore, tax policy has also encouraged employee contributions to pension funds by making them tax-deductible as well and enabling self-employed individuals to open up their own tax-sheltered pension plans, Keogh plans, and individual retirement accounts (IRAs). Because the benefits paid out of the pension fund each year are highly pre- dictable, pension funds invest in long-term securities, with the bulk of their asset holdings in bonds, stocks, and long-term mortgages. The key management issues for pension funds revolve around asset management: Pension fund managers try to hold assets with high expected returns and lower risk through diversification. They also use techniques we discussed in Chapter 9 to manage credit and interest-rate risk. The investment strategies of pension plans have changed radically over time. In the aftermath of World War II, most pension fund assets were held in government bonds, with less than 1% held in stock. However, the strong performance of stocks in the 1950s and 1960s afforded pension plans higher returns, causing them to shift their portfolios into stocks, currently on the order of two-thirds of their assets. As a result, pension plans now have a much stronger presence in the stock market: In the early 1950s, they held on the order of 1% of corporate stock outstanding; currently they hold on the order of 25%. Pension funds are now the dominant players in the stock market. Although the purpose of all pension plans is the same, they can differ in a num- ber of attributes. First is the method by which payments are made: If the benefits are determined by the contributions into the plan and their earnings, the pension is a defined-contribution plan; if future income payments (benefits) are set in advance, the pension is a defined-benefit plan. In the case of a defined-benefit plan, a further attribute is related to how the plan is funded. A defined-benefit plan is fully funded if the contributions into the plan and their earnings over the years are sufficient to pay out the defined benefits when they come due. If the contributions and earnings are not sufficient, the plan is underfunded. For example, if Jane Brown contributes $100 per year into her pension plan and the interest rate is 10%, after ten years the con- tributions and their earnings would be worth $1,753. 2 If the defined benefit on her 294 PART III Financial Institutions 2 The $100 contributed in year 1 would become worth $100 ϫ (1 ϩ 0.10) 10 ϭ $259.37 at the end of ten years; the $100 contributed in year 2 would become worth $100 ϫ (1 ϩ 0.10) 9 ϭ $235.79; and so on until the $100 contributed in year 10 would become worth $100 ϫ (1 ϩ 0.10) ϭ $110. Adding these together, we get the total value of these contributions and their earnings at the end of ten years: $259.37 ϩ $235.79 ϩ $214.36 ϩ $194.87 ϩ $177.16 ϩ $161.05 ϩ $146.41 ϩ $133.10 ϩ $121.00 ϩ $110.00 ϭ $1,753.11 pension plan pays her $1,753 or less after ten years, the plan is fully funded because her contributions and earnings will fully pay for this payment. But if the defined benefit is $2,000, the plan is underfunded, because her contributions and earnings do not cover this amount. A second characteristic of pension plans is their vesting, the length of time that a person must be enrolled in the pension plan (by being a member of a union or an employee of a company) before being entitled to receive benefits. Typically, firms require that an employee work five years for the company before being vested and qualifying to receive pension benefits; if the employee leaves the firm before the five years are up, either by quitting or being fired, all rights to benefits are lost. Private pension plans are administered by a bank, a life insurance company, or a pen- sion fund manager. In employer-sponsored pension plans, contributions are usually shared between employer and employee. Many companies’ pension plans are under- funded because they plan to meet their pension obligations out of current earnings when the benefits come due. As long as companies have sufficient earnings, under- funding creates no problems, but if not, they may not be able to meet their pension obligations. Because of potential problems caused by corporate underfunding, mis- management, fraudulent practices, and other abuses of private pension funds (Teamsters pension funds are notorious in this regard), Congress enacted the Employee Retirement Income Security Act (ERISA) in 1974. This act established minimum stan- dards for the reporting and disclosure of information, set rules for vesting and the degree of underfunding, placed restrictions on investment practices, and assigned the responsibility of regulatory oversight to the Department of Labor. ERISA also created the Pension Benefit Guarantee Corporation (called “Penny Benny”), which performs a role similar to that of the FDIC. It insures pension bene- fits up to a limit (currently over $40,000 per year per person) if a company with an underfunded pension plan goes bankrupt or is unable to meet its pension obligations for other reasons. Penny Benny charges pension plans premiums to pay for this insur- ance, and it can also borrow funds up to $100 million from the U.S. Treasury. Unfortunately, the problem of pension plan underfunding has been growing worse in recent years. In 1993, the secretary of labor indicated that underfunding had reached levels in excess of $45 billion, with one company’s pension plan alone, that of General Motors, underfunded to the tune of $11.8 billion. As a result, Penny Benny, which insures the pensions of one of every three workers, may have to foot the bill if com- panies with large underfunded pensions go broke. The most important public pension plan is Social Security (Old Age and Survivors’ Insurance Fund), which covers virtually all individuals employed in the private sector. Funds are obtained from workers through Federal Insurance Contribution Act (FICA) deductions from their paychecks and from employers through payroll taxes. Social Security benefits include retirement income, Medicare payments, and aid to the disabled. When Social Security was established in 1935, the federal government intended to operate it like a private pension fund. However, unlike a private pension plan, bene- fits are typically paid out from current contributions, not tied closely to a participant’s past contributions. This “pay as you go” system at one point led to a massive under- funding, estimated at over $1 trillion. The problems of the Social Security system could become worse in the future because of the growth in the number of retired people relative to the working Public Pension Plans Private Pension Plans CHAPTER 12 Nonbank Finance 295 www.ssa.gov/ The web site for the Social Security Administration contains information on your benefits available from social security. www.pbgc.gov/ The web site for the Pension Benefit Guarantee Corporation contains information about pensions and the insurance that it provides. population. Congress has been grappling with the problems of the Social Security sys- tem for years, but the prospect of a huge bulge in new retirees when the 77 billion baby boomers born between 1946 and 1964 start to retire in 2011 has resulted in calls for radical surgery on Social Security (see Box 1). State and local governments and the federal government, like private employers, have also set up pension plans for their employees. These plans are almost identical in operation to private pension plans and hold similar assets. Underfunding of the plans is also prevalent, and some investors in municipal bonds worry that it may lead to future difficulties in the ability of state and local governments to meet their debt obligations. Finance Companies Finance companies acquire funds by issuing commercial paper or stocks and bonds or borrowing from banks, and they use the proceeds to make loans (often for small amounts) that are particularly well suited to consumer and business needs. The finan- 296 PART III Financial Institutions Box 1 Should Social Security Be Privatized? In recent years, public confidence in the Social Security system has reached a new low. Some surveys suggest that young people have more confidence in the existence of flying saucers than they do in the gov- ernment’s promise to pay them their Social Security benefits. Without some overhaul of the system, Social Security will not be able to meet its future obligations. The government has set up advisory commissions and has been holding hearings to address this problem. Currently, the assets of the Social Security system, which reside in a trust fund, are all invested in U.S. Treasury securities. Because stocks and corporate bonds have higher returns than Treasury securities, many proposals to save the Social Security system suggest investing part of the trust fund in corporate securities and thus partially privatizing the system. Suggestions for privatization take three basic forms: 1. Government investment of trust fund assets in cor- porate securities. This plan has the advantage of pos- sibly improving the trust fund’s overall return, while minimizing transactions costs because it exploits the economies of scale of the trust fund. Critics warn that government ownership of private assets could lead to increased government intervention in the pri- vate sector. 2. Shift of trust fund assets to individual accounts that can be invested in private assets. This option has the advantage of possibly increasing the return on invest- ments and does not involve the government in the ownership of private assets. However, critics warn that it might expose individuals to greater risk and to transaction costs on individual accounts that might be very high because of the small size of many of these accounts. 3. Individual accounts in addition to those in the trust fund. This option has advantages and disadvantages similar to those of option 2 and may provide more funds to individuals at retirement. However, some increase in taxes would be required to fund these accounts. Whether some privatization of the Social Security system occurs is an open question. In the short term, Social Security reform is likely to involve an increase in taxes, a reduction in benefits, or both. For example, the age at which benefits begin is already scheduled to increase from 65 to 67, and might be increased further to 70. It is also likely that the cap on wages subject to the Social Security tax will be raised further, thereby increasing taxes paid into the system. [...]... with the bursting of the tech bubble in 2000, many of them lost much of their wealth when the value of their shares came down to earth When the corporation decides which kind of financial instrument it will issue, it offers them to underwriters—investment bankers that guarantee the corporation a price on the securities and then sell them to the public If the issue is small, only one investment banking. .. to the asset value of the fund Mutual funds also can be structured as a closed-end fund, in which a fixed number of nonredeemable shares are sold at an initial offering and are then traded like a common stock The market price of these shares fluctuates with the value of the assets held by the fund In contrast to the open-end fund, however, the price of the shares may be above or below the value of the. .. ME 393,5 46 7 46, 015 68 3,499 1 06, 184 49, 069 292 6, 389 2 ,68 3 747 ,69 1 10, 765 159,800 90,093 497 ,68 8 85, 366 812,029 64 ,333 $250 ϫ index $500 ϫ index $100 ϫ index $5 ϫ index CME CME CME CME 577 ,66 1 13 ,65 2 71,233 16, 193 £10 per index point LIFFE 460 ,997 12,500,000 yen 125,000 euros 100,000 Canadian $ 100,000 pounds 125,000 francs 500,000 new pesos CME CME CME CME CME CME 90,508 102,5 36 89 ,65 1 102,5 36 55,402... type of loan has grown most rapidly over the last 5 years? Ch a p ter 13 PREVIEW Financial Derivatives Starting in the 1970s and increasingly in the 1980s and 1990s, the world became a riskier place for the financial institutions described in this part of the book Swings in interest rates widened, and the bond and stock markets went through some episodes of increased volatility As a result of these... contracts, the quantities delivered and the delivery dates of futures contracts are standardized, making it more likely that different parties can be matched up in the futures market, thereby increasing the liquidity of the market In the case of the Treasury bond contract, the quantity delivered is $100,000 face value of bonds, and the delivery dates are set to be the last business day of March, June,... with a strike price of 115 (We assume that if Irving exercises the option, it is on the expiration date at the end of June and not before.) On the expiration date at the end of June, suppose that the underlying Treasury bond for the futures contract has a price of 110 Recall that on the expiration date, arbitrage forces the price of the futures contract to be the same as the price of the underlying bond,... and audits the brokers, traders, and exchanges to prevent fraud and to ensure the financial soundness of the exchanges In addition, the CFTC approves proposed futures contracts to make sure that they serve the public interest The most widely traded financial futures contracts listed in the Wall Street Journal and the exchanges where they are traded (along with the number of contracts outstanding, called... thought that the spread between prices on long-term Treasury bonds and long-term corporate bonds was too high, and bet that this “anomaly” would disappear and the spread would narrow In the wake of the collapse of the Russian financial system in August 1998, investors increased their assessment of the riskiness of corporate securities and as we saw in Chapter 6, the spread between corporates and Treasuries... the fund is hedged, because the decline in value of one security is matched by the rise in value of the other However, the fund is speculating on whether the spread between the price on the two securities moves in the direction predicted by the fund managers If the fund bets wrong, it can lose a lot of money, particularly if it has leveraged up its positions; that is, has borrowed heavily against these... give the purchaser the option, or right, to buy or sell the underlying financial instrument at a specified price, called the exercise price or strike price, within a specific period of time (the term to expiration) The seller (sometimes called the writer) of the option is obligated to buy or sell the financial instrument to the purchaser if the owner of the option exercises the right to sell or buy These . valuation after the initial public offering of shares in the company. However, with the bursting of the tech bubble in 2000, many of them lost much of their wealth when the value of their shares. the open-end fund, how- ever, the price of the shares may be above or below the value of the assets held by the fund, depending on factors such as the liquidity of the shares or the quality of. $110. Adding these together, we get the total value of these contributions and their earnings at the end of ten years: $259.37 ϩ $235.79 ϩ $214. 36 ϩ $194.87 ϩ $177. 16 ϩ $ 161 .05 ϩ $1 46. 41 ϩ $133.10