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Chapter Ten

The Investment Function in FinancialServices Management

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Key Topics

Nature and Functions of Investments

Investment Securities Available:

Advantages and Disadvantages Measuring Expected Returns

Taxes, Credit, and Interest-Rate Risks

Liquidity, Prepayment, and Other Risks Investment Maturity Strategies

Maturity Management Tools

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Functions of a Banks SecurityPortfolio

Stabilize the Banks Income Offset Credit Risk Exposure Provide Geographic Diversification Provide Backup Source of Liquidity Reduce Tax Exposure Serve as Collateral Hedge Against Interest Rate Risk Provide Flexibility Dress Up a Banks Balance Sheet

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Federal Regulators Require Written

Investment Policy The Quality or Degree of Default Risk

Exposure the Institution is Willing to Accept

The Desired Maturity Range and Degree ofMarketability Sought for All Securities

The Goals Sought for its InvestmentPortfolio

The Degree of Portfolio Diversification theInstitution Wishes to Achieve with itsInvestment Portfolio

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Investment Instruments Available to

Financial Firms

Money Market Instruments

Reach Maturity Within One Year

Low Risk

Ready Marketability

Capital Market Instruments

Maturity Beyond One Year Higher Expected Rate of Return

Capital Gains Potential

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Money Market Instruments Used by aBank

Treasury Bills Short-Term Treasury Notes and Bonds Federal Agency Securities Certificates of Deposit Eurocurrency Deposits Bankers Acceptances Commercial Paper Short-Term Municipal Obligations

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Capital Market Instruments Used by

a Bank Treasury Notes and Bonds Over OneYear to Maturity

Municipal Notes and Bonds

Corporate Notes and Bonds

Asset Backed Securities

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Other More Recent Investment

Instruments Structured Notes

Basic Characteristics Benefits

Recent Problems During Financial Crisis

Securitized Assets Pass-through securities CMOs Mortgage-backed bonds (guarantees from government

agencies; higher average yields; lack of good-qualityassets; superior liquidity)

Stripped Securities

PO and IO securities

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Dominant Investments Held By Banks in2007 Obligations of the U.S. Government and

Government Agencies About 60% of Banks Investments Overall Smaller Banks Hold a Higher Ratio Compared to

Large Banks State and Local Government Obligations

Nonmortgage-Related-Asset-Backed Securities

Hold Relatively Few Private-Sector Securities

Overall, Investment Securities Account for Less20% of Total Assets

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Quick Quiz

Why do banks and other institutions chooseto devote a significant portion of theirassets to investment securities?

What are the principal money market andcapital market instruments available toinstitutions today?

What types of investment securities do

banks seem to prefer the most? By size ofinstitutions? Explain.

What risks do securitized assets present toinstitutions investing in them?

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Factors Affecting the Choice of

Securities

Expected Rate of

Return Tax Exposure

Interest Rate Risk

Credit Risk Business Risk

Liquidity Risk

Call Risk

Prepayment Risk

Inflation Risk

PledgingRequirements

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Expected Rate of Return

Yield to Maturity

Holding Period Return

securitytheofvaluefacetheisFVwhereandsecurityon thepaymentscouponannualtheareCPwhere

YTM)(1

FV

YTM)(1

CPPV

n

n

1t

t

Bond

n

t

heldissecuritytheyearsofnumbertheisHPwhere

andforsoldbecansecuritythepricetheisPwhere

HPR)(1P

HPR)(1CPPV

HP

1tHP

t

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Tax Exposure

The Tax Status of State and LocalGovernment Bonds

Bank Qualified Bonds

Tax Swapping Tool

The Portfolio Shifting Tool

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Interest Rate Risk Rising Interest Rates Lowers the Value of

Previously Issued Bonds

Longest Term Bonds Suffer the GreatestLosses

Many Interest Rate Risk Tools IncludingFutures, Options, and Swaps Exist Today

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Default Risk

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Business Risk

Risk that the Economy of the Market Areathey Serve May Turn Down

Security Portfolio Can Offset This Risk

Securities Can be Purchased From Outside

Market Area Served

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Liquidity Risk

Breadth and Depth of Secondary Market

Number of Traders on an Given Day

Volume of Trades on Any Given Day

Treasury Securities are Generally the Most

Liquid

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Call Risk

Corporations and Some GovernmentsReserve the Right to Retire the Securities inAdvance of Their Maturity

Generally Called When Interest Rates a HaveFallen

Investor Must Find New Security Oftenwith a Lower Return

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Prepayment Risk

Specific to Asset-Backed Securities

Most Consumer Mortgages and Loans CanBe Paid Off Early

Caused by Loan Refinancing Which

Accelerate When Interest Rates Fall

Caused by Asset Turnover When BorrowersMove or are Not Able to Meet Loan

Payments and Asset is Sold

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Inflation Risk

Purchasing Power from a Security or LoanMay be Eroded by Rising Prices

Recently Developed Inflation Risk Hedge Treasury Inflation Protected Securities

Both Coupon Payments and PrincipalAdjusted Annually for Inflation Based onConsumer Price Index

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Pledging Requirements

Depository Institutions Cannot AcceptFederal, State and Local Government

Deposits Unless Acceptable Collateral isPledged

Generally Treasury Securities, GovernmentAgency Securities and Selected MunicipalSecurities Can Be Used as Collateral

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Investment Maturity Strategies

The Ladder or Spaced-Maturity Policy

The Front-End Load Maturity Policy

The Back-End Load Maturity Policy

The Barbell Strategy

The Rate Expectation Approach

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Maturity Management Tools The Yield Curve

Picture of How Market Interest Rates Differ AcrossDiffering Maturities

Constructed Most Easily with Treasury Securities Provides Information About Under and Over Priced

Securities Provides Information About the Risk Return Trade-

Off

Duration Present Value Weighted Average Maturity of the

Cash Flows Can Be Used to Insulate the Securities From Interest

Rate Changes

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Quick Quiz If a government bond is expected to mature

in two years and has a current price of$950, what is the bonds YTM if it has a par

value of $1000 and a promised couponrate of 10 percent? Suppose this bond issold one year after purchase for a price of$970. What would this investors holdingperiod return be?

How can the yield curve and duration helpan investment officer choose whichsecurities to acquire or sell?

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