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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