Chapter Ten

The Investment Function in

Banking and Financial Services
Management

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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
Reduce Tax Exposure
Serve as Collateral
Hedge Against Interest Rate Risk
Provide Flexibility
Dress Up a Banks Balance Sheet

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Money Market Instruments

Used by a Bank
Treasury Bills
Short-Term Treasury Notes and Bonds
Federal Agency Securities
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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Other More Recent

Investment Instruments
Structured Notes
Securitized Assets
Stripped Securities

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Factors Affecting the Choice

of Securities
Expected Rate of
Return
Tax Exposure
Interest Rate Risk
Credit Risk
Business Risk
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Bank Management and Financial

Liquidity Risk
Call Risk
Prepayment Risk
Inflation Risk
Pledging
Requirements
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Expected Rate of Return

Yield to Maturity

CPt
FVn
PVBond

t
(1 YTM) n
t 1 (1 YTM)
where CP are the annual coupon payments on the security and
where FV is the face value of the security
n

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
HP

where HP is the number of years the security is held

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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
Speculative
Grade

Investment
Grade
Moodys
Aaa
Aa
A
Baa

S&P
AAA
AA
A
BBB

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Bank Management and Financial

Moodys S&P
Ba BB
B
B
Caa
CCC
Ca CC
C
C
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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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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
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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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Investment Maturity
Strategies
The
The
The
The
The

Ladder or Spaced-Maturity Policy

Front-End Load Maturity Policy
Back-End Load Maturity Policy
Barbell Strategy
Rate Expectation Approach

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