2-Financial Markets Page 43 Wednesday, February 4, 2004 1:15 PM
Overview of Financial Markets, Financial Assets, and Market Participants 43York Stock Exchange, or in the over-the-counter market. The price of a
share in a closed-end fund is determined by supply and demand, so the
price can fall below or rise above the net asset value per share.Depository Institutions
Depository institutions are financial intermediaries that accept deposits.
They include commercial banks (or simply banks), savings and loan
associations (S&Ls), savings banks, and credit unions. It is common to
refer to depository institutions other than banks as “thrifts.” Deposi-
tory institutions are highly regulated and supervised because of the
important role that they play in the financial system.
The asset/liability problem that depository institutions face is quite
simple to explain—although not necessarily easy to solve. A depository
institution seeks to earn a positive spread between the assets it invests in
(loans and securities) and the cost of its funds (deposits and other
sources). This difference between income and cost is referred to as spread
income or margin income. The spread income should allow the institu-
tion to meet operating expenses and earn a fair profit on its capital.
In generating spread income a depository institution faces several
risks. These include credit risk, regulatory risk, and interest rate risk.
Regulatory risk is the risk that regulators will change the rules so as to
adversely impact the earnings of the institution. Simply put, interest rate
risk is the risk that a depository institution’s spread income and capital
will suffer because of changes in interest rates. This kind of risk can be
explained best by an illustration. To illustrate the impact on spread
income, suppose that a depository institution raises $100 million by
issuing a certificate of deposit that has a maturity of one year and by
agreeing to pay an interest rate of 7%. Ignoring for the time being the
fact that the depository institution cannot invest the entire $100 million
because of reserve requirements, suppose that $100 million is invested
in a U.S. Treasury security that matures in 15 years paying an interest
rate of 9%. Because the funds are invested in a U.S. Treasury security,
there is no credit risk.
It seems at first that the depository institution has locked in a spread
of 2% (9% minus 7%). This spread can be counted on only for the first
year, though, because the spread in future years will depend on the
interest rate this depository institution will have to pay depositors in
order to raise $100 million after the 1-year certificate of deposit
matures. If interest rates decline, the spread income will increase
because the depository institution has locked in the 9% rate. If interest
rates rise, however, the spread income will decline. In fact, if this depos-
itory institution must pay more than 9% to depositors for the next 14