Download 10-3

Chapter Ten
The Investment Function in Banking
and Financial Services Management
McGraw-Hill/Irwin
©2008 The McGraw-Hill Companies,
All Rights Reserved
Functions of a Bank’s Security
Portfolio
•
•
•
•
•
•
•
•
•
Stabilize the Bank’s 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 Bank’s Balance Sheet
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
10-2
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Written Investment Policy:
Regulator Guidelines
• The Quality or Degree of Default Risk Exposure
the Institution is Willing to Accept
• The Desired Maturity Range and Degree of
Marketability Sought for All Securities
• The Goals Sought for its Investment Portfolio
• The Degree of Portfolio Diversification the
Institution Wishes to Achieve with its
Investment Portfolio
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
10-3
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Money Market Instruments
Used by a Bank
• Treasury Bills
• Short-Term Treasury Notes and Bonds
• Federal Agency Securities
• Certificates of Deposit
• Eurocurrency Deposits
• Banker’s Acceptances
• Commercial Paper
• Short-Term Municipal Obligations
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
10-4
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Capital Market Instruments
Used by a Bank
• Treasury Notes and Bonds Over One
Year to Maturity
• Municipal Notes and Bonds
• Corporate Notes and Bonds
• Asset Backed Securities
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
10-5
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Other More Recent Investment
Instruments
• Structured Notes
• Securitized Assets
• Stripped Securities
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
10-6
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Dominant Investments Held By
Banks in 2004
• Obligations of the U.S. Government and
Government Agencies
• State and Local Government Obligations
• Nonmortgage-Related-Asset-Backed
Securities
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
10-7
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Factors Affecting the Choice of
Securities
• Expected Rate of
Return
• Tax Exposure
• Interest Rate Risk
• Credit Risk
• Business Risk
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
• Liquidity Risk
• Call Risk
• Prepayment Risk
• Inflation Risk
• Pledging
Requirements
10-8
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Expected Rate of Return
Yield to Maturity
n
CPt
FVn
PVBond  

t
(1  YTM) n
t 1 (1  YTM)
where CP are the annual coupon payments on the security and
where FV is the face value of the security
Holding Period Return
HP
CPt
P
PV  

HP
(1

HPR)
(1

HPR)
t 1
where P is the price the security can be sold for and
where HP is the number of years the security is held
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
10-9
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Tax Exposure
• The Tax Status of State and Local
Government Bonds
• Bank Qualified Bonds
• Tax Swapping Tool
• The Portfolio Shifting Tool
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
10-10
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Interest Rate Risk
• Rising Interest Rates Lowers the Value of
Previously Issued Bonds
• Longest –Term Bonds Suffer the Greatest
Losses
• Many Interest Rate Risk Tools Including
Futures, Options, and Swaps Exist Today
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
10-11
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Default Risk
Investment Grade
Moody’s
Aaa
Aa
A
Baa
S&P
AAA
AA
A
BBB
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
Speculative Grade
Moody’s
Ba
B
Caa
Ca
C
S&P
BB
B
CCC
CC
C
10-12
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Business Risk
• Risk that the Economy of the Market Area
they Serve May Turn Down
• Security Portfolio Can Offset This Risk
• Securities Can be Purchased From Outside
Market Area Served
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
10-13
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
10-14
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Call Risk
• Corporations and Some Governments
Reserve the Right to Retire the Securities
in Advance of Their Maturity
• Generally Called When Interest Rates a
Have Fallen
• Investor Must Find New Security – Often
with a Lower Return
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
10-15
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Prepayment Risk
• Specific to Asset-Backed Securities
• Most Consumer Mortgages and Loans
Can Be Paid Off Early
• Caused by Loan Refinancing Which
Accelerate When Interest Rates Fall
• Caused by Asset Turnover When
Borrowers Move or are Not Able to Meet
Loan Payments and Asset is Sold
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
10-16
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Inflation Risk
• Purchasing Power from a Security or Loan
May be Eroded by Rising Prices
• Recently Developed Inflation Risk Hedge
– Treasury Inflation Protected Securities
• Both Coupon Payments and Principal
Adjusted Annually for Inflation Based on
Consumer Price Index
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
10-17
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Pledging Requirements
• Depository Institutions Cannot Accept
Federal, State and Local Government
Deposits Unless Acceptable Collateral is
Pledged
• Generally Treasury Securities,
Government Agency Securities and
Selected Municipal Securities Can Be Used
as Collateral
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
10-18
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
10-19
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Maturity Management Tools
• The Yield Curve
– Picture of How Market Interest Rates Differ Across
Differing 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
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
10-20
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.