BBI2353 | Commercial Bank Management · PDF fileBBI2353 | Commercial Bank Management ... •Eurocurrency Deposits ... Popular Capital Market Investment Instruments

McGraw-Hill/Irwin

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

BBI2353 | Commercial Bank Management Prepared by Dr Khairul Anuar

L2: The Investment Function in

Financial-Services Management

www.lecturenotes.wordpress.com

1

McGraw-Hill/Irwin


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

10-2 2

McGraw-Hill/Irwin


Introduction

• Depository institutions devote a significant portion of their

asset portfolios to investments in securities

▫ Nonbank financial-service providers such as insurance

companies, pension funds, and mutual funds often devote an even

bigger portion of their assets to investment securities

• Investments perform a number of vital functions in the asset

portfolios of financial firms, providing income, liquidity,

diversification, and shelter for at least a portion of earnings

from taxation

• Investments also tend to stabilize earnings, providing

supplemental income when other sources of revenue are in

decline

10-3 3

McGraw-Hill/Irwin


EXHIBIT 10–1 Investments: The Crossroads Account on a

Depository Institution’s Balance Sheet

10-4 4

McGraw-Hill/Irwin


Investment Instruments Available to Financial

Firms

• The number of financial instruments available for financial

institutions to add to their portfolios is both large and growing

• Each financial instrument has different characteristics with

regard to expected yields, risk, sensitivity to inflation, and

sensitivity to shifting government policies and economic

conditions

• It is useful to divide them into two broad groups

1. Money market instruments

▫ Reach maturity within one year and are noted for their low risk and ready

marketability

2. Capital market instruments

▫ Have remaining maturities beyond one year and are generally noted for

their higher expected rate of return and capital gains potential

10-5 5

McGraw-Hill/Irwin



Firms (continued)

• Investment security portfolios help to

▫ 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

• Some authorities refer to investments as the crossroads

account

10-6 6

McGraw-Hill/Irwin



Firms (continued)

• Federal regulations stress the need for every regulated

institution to develop a written investment policy giving

specific guidelines on

▫ 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 purchased

▫ The goals sought for its investment portfolio

▫ The degree of portfolio diversification to reduce risk the

institution wishes to achieve

10-7 7

McGraw-Hill/Irwin


Popular Money Market Investment Instruments

• 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

10-8 8

McGraw-Hill/Irwin


Popular Capital Market Investment Instruments

• Treasury Notes and Bonds

• Municipal Notes and Bonds

• Corporate Notes and Bonds

10-9 9

McGraw-Hill/Irwin


Investment Instruments Developed More

Recently

• Structured Notes

▫ Arose from security dealers who assembled pools of federal

agency securities and offered investments officers a packaged

investment whose interest yield could be reset periodically based

on what happened to a reference interest rate

• 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

▫ Principal-Only (PO) and Interest-Only (IO) securities

10-10 10

McGraw-Hill/Irwin


Investment Securities Held by Banks

• Just a few types of securities dominate bank investment

portfolios

1. U.S. government (especially Treasury) securities

2. Obligations of various federal agencies such as the Federal

National Mortgage Association (FNMA), the Federal

Home Loan Mortgage Corporation (FHLMC), and the

Government National Mortgage Association (GNMA),

especially in the form of mortgage-backed securities

3. State and local government obligations (municipals)

4. Nonmortgage-related asset-backed securities (such as

obligations backed by credit card and automobile loans)

5. Equities (common and preferred stock)

10-11 11

McGraw-Hill/Irwin


TABLE 10–3 Investment Securities Held by FDIC-Insured

Commercial Banks, 2010

10-12 12

McGraw-Hill/Irwin


Factors Affecting Choice of Investment

Securities

• The principal factors bearing on which investments are

chosen include

1. Expected rate of return

2. Tax exposure

3. Interest rate risk

4. Credit or default risk

5. Business risk

6. Liquidity risk

7. Call risk

8. Prepayment risk

9. Inflation risk

10. Pledging requirements

10-13 13

McGraw-Hill/Irwin



Securities (continued)

• Expected Rate of Return

▫ Yield to Maturity (YTM) versus Holding Period Yield

(HPY)

▫ Example

▫ An investments officer is considering purchasing a $1,000

par-value Treasury note that promises an 8 percent coupon

rate and matures in five years with a current of $900

10-14 14

McGraw-Hill/Irwin




• Tax Exposure

▫ The tax status of state and local government bonds

▫ Bank qualified bonds

▫ Tax swapping tool

▫ The portfolio shifting tool

10-15 15

McGraw-Hill/Irwin




• Tax Exposure

▫ To evaluate the attractiveness of municipals, financial firms

calculate the net after-tax returns and/or the tax-equivalent

yields to enable comparisons with other investment

alternatives

▫ The net after-tax return of bank-qualified municipals is

calculated as

10-16 16

McGraw-Hill/Irwin




• Tax Exposure

▫ The tax advantage of a qualified bond is determined as

10-17 17

McGraw-Hill/Irwin




• Tax Exposure

▫ Suppose a bank purchases a bank-qualified bond from a small city,

county, or school district and the bond carries a nominal gross rate of

return of 7 percent

▫ The bank had to borrow the funds needed to make this purchase at an

interest rate of 6.5 percent and is in the 35 percent tax bracket

▫ The bond’s net annual after-tax return (after all funding costs and taxes)

must be:

10-18 18

McGraw-Hill/Irwin




• Tax Exposure

▫ In years when loan revenues are high, it may be beneficial to

engage in tax swapping

▫ In a tax swap, the lending institution sells lower-yielding

securities at a loss in order to reduce its current taxable income,

while simultaneously purchasing new higher-yielding securities

in order to boost future returns

▫ Lending institutions also do a great deal of portfolio shifting in

their holdings of investment securities, with both taxes and higher

returns in mind

10-19 19

McGraw-Hill/Irwin




• 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

10-20 20

McGraw-Hill/Irwin




• Credit or Default Risk

▫ The risk that the security issuer may default on the principal

or interest owed

▫ Three major credit ratings agencies

1. Moody’s

2. Standard & Poor’s

3. Fitch’s Rating Service

10-21 21

McGraw-Hill/Irwin


TABLE 10–4 Default Risk Ratings on Marketable Investment

Securities (including long-term corporate obligations)

10-22 22

McGraw-Hill/Irwin




• Business Risk

▫ Risk that the economy of the market area the financial

institution serves may slow down

▫ Security portfolio can offset this risk

▫ Securities can be purchased from outside the market area

served

• Liquidity Risk

▫ Can a security be converted into cash quickly and easily

without significant loss in value?

▫ A key issue – the breadth and depth of a security’s resale

market

10-23 23

McGraw-Hill/Irwin




• Call Risk

▫ Many corporations and some governments that issue

securities reserve the right to call in instruments in advance

of maturity and pay them off

▫ Because such calls usually take place when market interest

rates have declined (and the borrower can get lower interest

costs), the financial firm investing in callable securities runs

the risk of an earnings loss because it must reinvest its

recovered funds at lower interest rates

10-24 24

McGraw-Hill/Irwin




• Prepayment Risk

▫ A form of risk specific to asset-backed securities

▫ This form of risk arises because the realized interest and

principal payments from a pool of securitized loans may be

quite different from the cash flows expected originally

▫ Variations in cash flow to holders of the securities backed

by these loans can arise from

1. Loan refinancings

2. Turnover of the assets behind the loans

10-25 25

McGraw-Hill/Irwin




• Prepayment Risk

▫ This means that the market value of a loan-backed security

depends not only upon the promised cash flows it will

generate, but also on the projected prepayments and loan

defaults that occur

10-26 26

McGraw-Hill/Irwin




• Inflation Risk

▫ Purchasing power from a security or loan may be eroded by

rising prices

▫ Recently developed inflation risk hedge – Treasury Inflation

Protected Securities (TIPS)

▫ Both coupon payments and principal adjusted annually for

inflation based on Consumer Price Index

▫ TIPS do not protect investors from all the effects of inflation,

such as moving into higher tax brackets

▫ Carry market risk like regular bonds

▫ Tend to be less liquid

10-27 27

McGraw-Hill/Irwin




• Pledging Requirements

▫ Depository institutions in the United States cannot accept

deposits from federal, state, and local governments unless

they post collateral acceptable to these governmental units

▫ State and local government deposit pledging requirements

differ widely from state to state, though most allow a

combination of federal and municipal securities to meet

government pledging requirements

▫ If a financial institution uses repurchase agreements (RPs)

to raise money, it must pledge some of its securities (usually

Treasury and federal agency issues) as collateral in order to

receive funds at the lowest RP rate

10-28 28

McGraw-Hill/Irwin


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

10-29 29

McGraw-Hill/Irwin


EXHIBIT 10–2 Alternative Maturity Strategies for Managing

Investment Portfolios

10-30 30

McGraw-Hill/Irwin




10-31 31

McGraw-Hill/Irwin




10-32 32

McGraw-Hill/Irwin


EXHIBIT 10–3 Additional Maturity Strategies for Managing


10-33 33

McGraw-Hill/Irwin


EXHIBIT 10–3 Additional Maturity Strategies for Managing


10-34 34

McGraw-Hill/Irwin


Maturity Management Tools

• The Yield Curve

▫ Picture of how market interest rates differ across various

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

10-35 35

McGraw-Hill/Irwin


EXHIBIT 10–4 The Yield Curve

10-36 36

McGraw-Hill/Irwin


Maturity Management Tools (continued)

• Immunization ▫ Duration also suggests a way to minimize damage to an

investing institution’s earnings that changes in market interest rates may cause

▫ Duration gives the investments officer a tool to reduce his or her institution’s exposure to interest rate risk

▫ Portfolio immunization is protecting securities purchased from loss of return, no matter which way interest rates go

10-37 37

McGraw-Hill/Irwin


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.

• 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?

10-38 38

Documents

BBI2353 | Commercial Bank Management · PDF fileBBI2353 | Commercial Bank Management ... •Eurocurrency Deposits ... Popular Capital Market Investment Instruments