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Chapter Ten
The Investment Function in FinancialServices Management
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2008 The McGraw-Hill Companies, Inc., All Rights Reserved.McGraw-Hill/IrwinBank Management and Financial Services, 7/e
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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