Banks investment portfolio

Chapter 10

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Key Topics
Nature and Functions of Investments Investment Securities Available: Advantages and Disadvantages Factors Affecting the Choice of Securities Investment Maturity Strategies Maturity Management Tools (optional reading)

Why banks hold securities

Primary function of a bank is to make loans to support business investment and consumer spending But loans are generally illiquid, and risky A portion of assets are dedicated to investment securities

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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 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

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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 a Bank

Treasury Bills Short-Term Treasury Notes and Bonds 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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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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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 Pledging Requirements

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Expected Rate of Return

Yield to Maturity
n

CPt FVn PVBond t n (1 YTM ) (1 YTM ) t 1 where CP are the annual coupon paymentson the security and where FV is the face value of the security

Holding Period Return

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
HP

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Tax Exposure
The Tax Status of State and Local Government Bonds

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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

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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

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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

Ladder policy

Front-end load

Back-end load

Barbell strategy

Rate-expectation

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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 Trade-Off Duration Present Value Weighted Average Maturity of the Cash Flows Can Be Used to Insulate the Securities From Interest Rate Changes