The Investment Function in Financial-Services Management Chapter Ten The Investment Function in Financial-Services Management McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Key Topics Functions of investments Investment securities available 10-2 Key Topics Functions of investments Investment securities available Risks in security investments Investment maturity strategies

Functions of a Bank’s Security Portfolio 10-3 Functions of a Bank’s Security Portfolio 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

Functions of a Bank’s Security Portfolio Cash Liabilities Add to investments when cash is high Sell investments when cash is low When deposits are low use investments as collateral for non-deposit borrowings Return investments as collateral to the investment portfolio when deposit growth is high Investments Non-deposit borrowings Sell investments when loan demand is high Add to investments when loan demand is low Loans

Instruments Available to Financial Firms 10-5 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

10-6

Money Market Instruments Used by a Bank 10-7 Money Market Instruments Used by a Bank 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

Capital Market Instruments 10-8 Capital Market Instruments Treasury notes and bonds over one year to maturity Municipal notes and bonds Corporate notes and bonds Asset backed securities

Dominant Investments Held By Banks in 2007 10-9 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

Dominant Investments Held By Banks in 2007 Types of securities held Smallest banks Medium-size banks Largest banks All U.S. government obligations 73.3 70.6 69 Securities issued by states and municipals 18.7 19.5 4.8 Asset-backed securities 0.3 5.3 Other domestic debt securities 2.9 12.2 Foreign debt securities 0.1 7.7 Equity securities 0.8 1.1 1 Total investment securities 100

Factors Affecting the Choice of Securities 10-11 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

10-12 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

10-13 Default Risk

10-14 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

Liquidity Risk Breadth and depth of secondary market 10-15 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

10-16 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

Prepayment Risk Specific to asset-backed securities 10-17 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

10-18 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

Pledging Requirements 10-19 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

Investment Maturity Strategies 10-20 Investment Maturity Strategies The Ladder or Spaced-Maturity Policy (average) The Front-End Load Maturity Policy (short-term) The Back-End Load Maturity Policy (long-term) The Barbell Strategy (half of short-term, half of long- term) The Rate Expectation Approach