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

2. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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

3. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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 Provide Flexibility Dress Up a Bank’s Balance Sheet 10-3

4. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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 10-4

5. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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 10-5

6. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 10-6

7. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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 10-7

8. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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 10-8

9. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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 10-9

10. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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 10-10

11. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 10-11

12. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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? 10-12

13. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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 10-13

14. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Expected Rate of Return Yield to Maturity Holding Period Return 10-14

15. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Tax Exposure The Tax Status of State and Local Government Bonds Bank Qualified Bonds Tax Swapping Tool The Portfolio Shifting Tool 10-15

16. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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 10-16

17. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Default Risk 10-17

18. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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 10-18

19. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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 10-19

20. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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 10-20

21. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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 10-21

22. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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 10-22

23. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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 10-23

24. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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 10-24

25. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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 10-25

26. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Quick Quiz 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? 10-26