Chapter Ten The Investment Function in Financial Services

Chapter Ten The Investment Function in Financial. Services Management Mc. Graw-Hill/Irwin Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

10 -2 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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 -3 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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 -4 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 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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 -5 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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 -6 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 -7 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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 -8 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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 -9 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-quality assets; superior liquidity) • Stripped Securities ▫ PO and IO securities Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 -10 Dominant Investments Held By Banks in 2007 • 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 Less 20% of Total Assets Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 -11 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 -12 Quick Quiz • Why do banks and other institutions choose to devote a significant portion of their assets to investment securities? • What are the principal money market and capital market instruments available to institutions today? • What types of investment securities do banks seem to prefer the most? By size of institutions? Explain. • What risks do securitized assets present to institutions investing in them? Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 -13 Factors Affecting the Choice of Securities • Expected Rate of Return • Tax Exposure • Interest Rate Risk • Credit Risk • Business Risk Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e • Liquidity Risk • Call Risk • Prepayment Risk • Inflation Risk • Pledging Requirements © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 -14 Expected Rate of Return Yield to Maturity Holding Period Return Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 -15 Tax Exposure • The Tax Status of State and Local Government Bonds • Bank Qualified Bonds • Tax Swapping Tool • The Portfolio Shifting Tool Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 -16 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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 -17 Default Risk Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 -18 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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 -19 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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 -20 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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 -21 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 Mc. Graw-Hill/Irwin 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. Bank Management and Financial Services, 7/e

10 -22 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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 -23 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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 -24 Investment Maturity Strategies • • • The The The Ladder or Spaced-Maturity Policy Front-End Load Maturity Policy Back-End Load Maturity Policy Barbell Strategy Rate Expectation Approach Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 -25 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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

10 -26 Quick Quiz • If a government bond is expected to mature in two years and has a current price of $950, what is the bond’s YTM if it has a par value of $1000 and a promised coupon rate of 10 percent? Suppose this bond is sold one year after purchase for a price of $970. What would this investor’s holding period return be? • How can the yield curve and duration help an investment officer choose which securities to acquire or sell? Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.