Chapter Ten

The Investment Function in Financial-Services Management

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Key Topics

•Functions of investments •Investment securities available•Risks in security investments•Investment maturity strategies

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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

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Functions of a Bank’s Security Portfolio

Investments

Cash

Loans

Non-deposit borrowings

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

Sell investments when loan demand is high

Add to investments when loan demand is low

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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•Federal Agency Securities•Certificates of Deposit•Eurocurrency Deposits•Banker’s Acceptances•Commercial Paper•Short-Term Municipal Obligations

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Capital Market Instruments

•Treasury notes and bonds over one year to maturity

•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 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

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Dominant Investments Held By Banks in 2007

Types of securities heldSmallest

banksMedium-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 0.3 5.3

Other domestic debt securities 2.9 4.8 12.2

Foreign debt securities 0 0.1 7.7

Equity securities 0.8 1.1 1

Total investment securities 100 100 100

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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•Pledging

Requirements

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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

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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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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

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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

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