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Chapter Ten
The Investment Function in Financial Services Management

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 Security Portfolio


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 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 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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 a Bank


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 One Year 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-quality assets; superior liquidity) Stripped Securities PO and IO securities McGraw-Hill/Irwin
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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
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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?
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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Factors Affecting the Choice of Securities


Expected Rate of Return Tax Exposure Interest Rate Risk Credit Risk Business Risk
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Liquidity Risk Call Risk Prepayment Risk Inflation Risk Pledging Requirements
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Expected Rate of Return


CPt FVn PVBond Maturity t Yield to (1 YTM) n t 1 (1 YTM) whereCP are the annual coupon payments on the security and where FV is the face value of the security
n

Holding Period Return


CPt P PV (1 HPR) (1 HPR) HP t 1 where P is the price the security can be sold for and where HP is the number of years the securityis held
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

HP

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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 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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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
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Default Risk

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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

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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 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 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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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 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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
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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 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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Investment Maturity Strategies


The The The The The Ladder or Spaced-Maturity Policy Front-End Load Maturity Policy Back-End Load Maturity Policy Barbell Strategy Rate Expectation Approach

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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 TradeOff 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 coupon rate of 10 percent? Suppose this bond is sold one year after purchase for a price of $970. What would this investors holding period return be? How can the yield curve and duration help an investment officer choose which securities to acquire or sell? McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

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