06 Investment

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Banks investment

portfolioChapter 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)

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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 ofMarketability 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 toMaturity

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 GovernmentAgencies About 60% of Banks Investments Overall

Smaller Banks Hold a Higher Ratio Compared to LargeBanks

State and Local Government Obligations

Nonmortgage-Related-Asset-Backed Securities

Hold Relatively Few Private-Sector Securities

Overall, Investment Securities Account for Less 20% ofTotal 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

PledgingRequirements

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Expected Rate of Return

Yield to Maturity

Holding Period Return

securitytheofvaluefacetheisFVwhere

ansecurityon thepaymentscouponannualtheareCPwhereYTM)(1

FV

YTM)(1

CPPV

n

n

1

t

t

Bond

n

t

heldissecuritytheyearsofnumbertheisHPwhere

andforsoldbecansecuritythepricetheisPwhere

HPR)(1

P

HPR)(1

CPPVHP

1tHP

t

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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

LongestTerm 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 ServeMay Turn Down

Security Portfolio Can Offset This Risk

Securities Can be Purchased From Outside MarketArea 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 theRight to Retire the Securities in Advance of TheirMaturity

Generally Called When Interest Rates a Have Fallen

Investor Must Find New Security Often with a LowerReturn

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Inflation Risk

Purchasing Power from a Security or Loan May beEroded by Rising Prices

Recently Developed Inflation Risk Hedge TreasuryInflation Protected Securities

Both Coupon Payments and Principal AdjustedAnnually for Inflation Based on Consumer Price Index

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Pledging Requirements

Depository Institutions Cannot Accept Federal,State and Local Government Deposits UnlessAcceptable Collateral is Pledged

Generally Treasury Securities, Government AgencySecurities and Selected Municipal Securities Can BeUsed 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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Ladder policy


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Front-end load


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Back-end load


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Barbell strategy


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Rate-expectation

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Maturity Management Tools

The Yield Curve

Picture of How Market Interest Rates Differ Across DifferingMaturities

Constructed Most Easily with Treasury Securities

Provides Information About Under and Over PricedSecurities

Provides Information About the Risk Return Trade-Off

Duration

Present Value Weighted Average Maturity of the CashFlows

Can Be Used to Insulate the Securities From Interest RateChanges

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Documents

06 Investment