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Financial Markets and
Institutions
Instructor's Manual
Miskhin and Eakins
Financial Markets and
Institutions
Tenth Edition
Frederic Mishkin
Stanley Eakins
Table of Contents
1. Why Study Financial Markets and Institutions? ........ 2
2. Overview of the Financial System ..................... 5
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3. What Do Interest Rates Mean, and What Is Their Role
in Valuation? ............................................ 8
4. Why Do Interest Rates Change? ....................... 14
5. How Do Risk and Term Structure Affect Interest
Rates? .................................................. 22
6. Are Financial Markets Efficient? .................... 29
7. Why Do Financial Institutions Exist? ................ 32
8. Why Do Financial Crises Occur, and Why Are They So
Damaging to
the Economy? .......................................... 38
9. Central Banks and the Federal Reserve System ........ 43
10. Conduct of Monetary Policy .......................... 47
11. The Money Markets ................................... 54
12. The Bond Market ..................................... 60
13. The Stock Market .................................... 66
14. The Mortgage Markets ................................ 72
15. The Foreign Exchange Market ......................... 82
16. The International Financial System .................. 88
17. Banking and the Management of Financial
Institutions ............................................ 93
18. Financial Regulation ............................... 101
19. Banking Industry: Structure and Competition ........ 108
20. The Mutual Fund Industry ........................... 111
21. Insurance Companies and Pension Funds .............. 118
22. Investment Banks, Security Brokers and Dealers, and
Venture Capital Firms .................................. 123
23. Risk Management in Financial Institutions .......... 127
24. Hedging with Financial Derivatives ................. 137
Chapters on the Web
25. Financial Crises in Emerging Market Economies ...... 147
26. Savings Associations and Credit Unions ............. 150
27. Finance Companies .................................. 153
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Sure! I’ll expand on the topics related to "Taxation of Business Entities," providing a more detailed exploration. This overview will cover fundamental concepts, applications, and implications relevant to the study of business taxation.---### Overview
of Business Entities#### 1. Types of Business EntitiesBusiness entities can be categorized based on ownership structure and tax treatment. Understanding these types is crucial for determining tax obligations and benefits.- **Sole Proprietorships**: -
Owned by a single individual, this is the simplest form of business entity. Income is reported on the owner’s personal tax return (Form 1040, Schedule C), which simplifies tax filing but also means personal liability for debts and obligations.-
**Partnerships**: - Consisting of two or more individuals, partnerships do not pay federal income taxes. Instead, they are considered pass-through entities, meaning income is taxed at the partners' individual rates. Form 1065 is used to report
partnership income, while partners receive Schedule K-1 to report their share on their returns.- **Corporations**: - Corporations are separate legal entities that provide limited liability protection to their owners (shareholders). C-Corporations face
double taxation: once at the corporate level on profits and again at the individual level when dividends are distributed. S-Corporations, on the other hand, are pass-through entities but have restrictions on ownership and number of shareholders.-
**Limited Liability Companies (LLCs)**: - LLCs combine the flexibility of partnerships with the liability protection of corporations. An LLC can choose to be taxed as a sole proprietorship, partnership, or corporation, allowing for strategic tax
planning. ### 2. Tax Implications of Each Entity TypeUnderstanding the tax implications of each entity type is critical for effective business planning.- **Sole Proprietorships**: - Income is taxed at the owner’s individual tax rate. All profits and
losses are reported on the owner’s tax return. This simplicity, however, can expose owners to significant personal risk.- **Partnerships**: - Each partner reports their share of income and losses on their personal returns, allowing for loss deductions.
Partners are also subject to self-employment taxes on their share of the income, which can significantly impact tax liability.- **Corporations**: - C-Corporations are taxed at the corporate tax rate (currently 21%). Dividends are taxed again at the
shareholder level. S-Corporations avoid double taxation, but there are restrictions on the number and type of shareholders.- **Limited Liability Companies (LLCs)**: - By default, single-member LLCs are treated as sole proprietorships for tax
purposes, while multi-member LLCs are treated as partnerships. However, they can elect to be taxed as a corporation if beneficial.### Key Tax Concepts#### 1. Income RecognitionIncome recognition is a fundamental principle in taxation,
determining when income must be reported.- **Cash vs. Accrual Accounting**: - Businesses can choose between cash and accrual methods. Cash accounting recognizes income when received and expenses when paid, making it straightforward.
Accrual accounting recognizes income when earned and expenses when incurred, aligning revenue with the period it relates to, but can complicate cash flow management.#### 2. DeductionsDeductions reduce taxable income, directly impacting tax
liability.- **Ordinary and Necessary Expenses**: - The IRS allows deductions for expenses that are ordinary (common in the industry) and necessary (helpful and appropriate for the business). Common deductions include rent, utilities, salaries, and
professional fees.- **Limits on Deductions**: - Certain expenses, such as meals and entertainment, have specific limits (e.g., meals are typically only 50% deductible).
Chapter 1
Why Study Financial Markets
and Institutions?
Why Study Financial Markets?
Debt Markets and Interest Rates
The Stock Market
The Foreign Exchange Market
Why Study Financial Institutions?
Structure of the Financial System
Financial Crises
Central Banks and the Conduct of Monetary Policy
The International Financial System
Banks and Other Financial Institutions
Financial Innovation
Managing Risk in Financial Institutions
Applied Managerial Perspective
How We Will Study Financial Markets and Institutions
Exploring the Web
Collecting and Graphing Data
Web Exercise
Concluding Remarks
Overview and Teaching Tips
Before embarking on a study of financial markets and institutions, the student must be convinced
that this subject is worth studying. Chapter 1 pursues this goal by showing the student that
financial markets and institutions is an exciting field because it focuses on phenomena that affect
everyday life. An additional purpose of Chapter 1 is to provide an overview for the entire book,
previewing the topics that will be covered in later chapters. The chapter also provides the students
with a guide as to how they will be studying financial markets and institutions with a unifying,
analytic framework and an applied managerial perspective.
In teaching this chapter, the most important goal should be to get the student excited about the
material. I have found that talking about the data presented in the figures helps achieve this goal by
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showing the students that the subject matter of financial markets and institutions has real-world
implications that they should care about. In addition, it is important to emphasize to the students that
the course will have an applied managerial perspective, which they will find useful later in their
careers. Going through the web exercise is also a way of encouraging the students to use the web to
further their understanding of financial markets and institutions.
Sure! I’ll expand on the topics related to "Taxation of Business Entities," providing a more detailed exploration. This overview will cover fundamental concepts, applications, and implications relevant to the study of
business taxation.---### Overview of Business Entities#### 1. Types of Business EntitiesBusiness entities can be categorized based on ownership structure and tax treatment. Understanding these types is crucial for
determining tax obligations and benefits.- **Sole Proprietorships**: - Owned by a single individual, this is the simplest form of business entity. Income is reported on the owner’s personal tax return (Form 1040,
Schedule C), which simplifies tax filing but also means personal liability for debts and obligations.- **Partnerships**: - Consisting of two or more individuals, partnerships do not pay federal income taxes. Instead,
they are considered pass-through entities, meaning income is taxed at the partners' individual rates. Form 1065 is used to report partnership income, while partners receive Schedule K-1 to report their share on their
returns.- **Corporations**: - Corporations are separate legal entities that provide limited liability protection to their owners (shareholders). C-Corporations face double taxation: once at the corporate level on profits
and again at the individual level when dividends are distributed. S-Corporations, on the other hand, are pass-through entities but have restrictions on ownership and number of shareholders.- **Limited Liability
Companies (LLCs)**: - LLCs combine the flexibility of partnerships with the liability protection of corporations. An LLC can choose to be taxed as a sole proprietorship, partnership, or corporation, allowing for
strategic tax planning. ### 2. Tax Implications of Each Entity TypeUnderstanding the tax implications of each entity type is critical for effective business planning.- **Sole Proprietorships**: - Income is taxed at the
owner’s individual tax rate. All profits and losses are reported on the owner’s tax return. This simplicity, however, can expose owners to significant personal risk.- **Partnerships**: - Each partner reports their share
of income and losses on their personal returns, allowing for loss deductions. Partners are also subject to self-employment taxes on their share of the income, which can significantly impact tax liability.-
**Corporations**: - C-Corporations are taxed at the corporate tax rate (currently 21%). Dividends are taxed again at the shareholder level. S-Corporations avoid double taxation, but there are restrictions on the
number and type of shareholders.- **Limited Liability Companies (LLCs)**: - By default, single-member LLCs are treated as sole proprietorships for tax purposes, while multi-member LLCs are treated as
partnerships. However, they can elect to be taxed as a corporation if beneficial.### Key Tax Concepts#### 1. Income RecognitionIncome recognition is a fundamental principle in taxation, determining when income
must be reported.- **Cash vs. Accrual Accounting**: - Businesses can choose between cash and accrual methods. Cash accounting recognizes income when received and expenses when paid, making it
straightforward. Accrual accounting recognizes income when earned and expenses when incurred, aligning revenue with the period it relates to, but can complicate cash flow management.#### 2.
DeductionsDeductions reduce taxable income, directly impacting tax liability.- **Ordinary and Necessary Expenses**: - The IRS allows deductions for expenses that are ordinary (common in the industry) and
necessary (helpful and appropriate for the business). Common deductions include rent, utilities, salaries, and professional fees.- **Limits on Deductions**: - Certain expenses, such as meals and entertainment, have
specific limits (e.g., meals are typically only 50% deductible).
Answers to End-of-Chapter Questions
1. Well-performing financial markets tend to allocate funds to
its more efficient use, thereby allowing the best investment
opportunities to be undertaken. The improvement in the
allocation of funds results in a more efficient economy, which
stimulates economic growth (and thereby poverty reduction).
2. Businesses would cut investment spending because the cost of
financing this spending is now higher, and consumers would be
less likely to purchase a house or a car because the cost of
financing their purchase is higher.
3. A change in interest rates affects the cost of acquiring funds
for financial institutions, as well as changes the income on
assets such as loans, both of which affect profits. In
addition, changes in interest rates affect the price of assets
such as stocks and bonds that the financial institution owns,
which can lead to profits or losses.
4. While it is true that there are many interest rates in the
economy, like the interest rate paid by a corporate bond or
the interest rate charged to a homeowner, it is also true that
all of these interest rates tend to move together. Evidence
shows that movements in different interest rates over time are
in large part explained by the same events, and thereby allow
economists to refer to “the” interest rate when trying to
determine its movements.
5. The lower price for a firm’s shares means that it can raise a
smaller amount of funds, and so investment in plant and
equipment will fall.
6. A bond is a debt instrument, which entitles the owner to
receive periodic amounts of money (predetermined by the
characteristics of the bond) until its maturity date. A common
stock, however, represents a share of ownership in the
institution that has issued the stock. In addition to its
definition, it is not the same to hold bonds or stock of a
given corporation, since regulations state that stockholders
