In this chapter we will learn some of the investment strategies that banks can pursue in order to maximize the income from their investment portfolio while maintaining a reasonable amount of liquidity. Why banks held a large portion of their funds in investment securities? 1. 2. 3. 4. 5. 6. Alternative source of income, especially when loan demand is low. Liquidity. Additional reserve of funds over and above secondary reserves. Could serve as collateral. Asset diversification/ reduction of risk. To reduce taxes (investing in municipals).
Bank Investment Policy • • • Seeks to maximize the return per unit risk on the investment portfolio of securities. Required so management can make decisions consistent with the overall goals of the organization. Should be written out as a guide to managers in allocating responsibilities, setting investment goals, directing permissible securities purchases and evaluating portfolio performance. For an example of the investment policy of a bank, see tables 7A1 & 7A2 on pages 207 to 210 of the textbook Federal Reserve System, securities classified into three categories: U.S. Treasuries, Federal Agencies, Municipals (No limits). Type I Low Risk: Type II Moderate Risk: Federal and State Agencies (Self imposed limits). Type III Higher Risk: Corporate and asset backed securities.
Type of Investment Securities Can be classified as securities with maturities over one year. -Two main categories: U.S. Government and Agency Securities State and Political Subdivisions, or municipal securities -High quality Corporate Bonds (subject to restrictions) -Common Stock (Allowed in subsidiaries of banks or bank holding companies that are legally separate entities under the Financial Services Modernization Act of 1,999.
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U.S. Government Securities: Treasury Notes and Bonds with 1 to 5 years maturities. Highly liquid. Agency Securities: They are not direct obligations of the U.S. Include, Ginnie Mae, Freddie Mac, FHl, FCA, FLB, SBA, Fannie Mae. Issued by states and local governments to finance various public works. Offer higher yield than U.S. and Agency securities because. are subject to default risk Long term securities issued by a private corporation. Higher rate of default than state and local governments.
Formula to Compare Yields on Municipals with Taxable Bonds: YTM TE = [ ( YTM m/ 1-T ) ] – [ (1.0 x Ave. Cost of Funds x T )] ( 1- T )
YTM m = Yield to Maturity Municipal T = Tax Rate YTMTE = Tax Equivalent YTM on Municipals Ave. Cost of Funds = Based on IRS policies Example: YTM m = 8% Tax Rate = 34% Ave. Cost of Funds = 7% 100% of tax = Not deductible
YTM TE =
0.08 1 - 0.34 0.1212 0.085
1.0 x 0.07 x 0.34 1 – 0.34 0.036
YTM TE = YTM TE =
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Evaluating Investment Risk
Probability that principal and interest will not be paid on time
-Standard & Poors (S&P) and Moodys: Agencies that rate corporate and municipals bonds, common stocks, preferred stocks and commercial paper.
Highest Grade Aaa AAA High (Slightest lower quality) Aa AA Upper Medium Grade A A Medium Grade Baa BBB _____________________________________________________________________ Junk Bonds Lower/Medium Ba BB Speculative/Questionable B/Caa/Ca/C B/CCC/CC/C Bonds in Default DDD/DD/D DDD/DD/D
-Bond prices are Inversely related to credit risk: Lower quality bonds have higher yields than higher quality bonds.
-Price Risk: Inverse relationship between changes en interest rates and the price of securities.
-To evaluate the price risk in a bond: Need to consider the expected change in interest rates and the duration of the bond. (Duration is a proxy for price risk)
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Formula to calculate the price risk:
^P= -DxBxAi (1 + i ) ^P= D = B = Ai = Price of the Bond Duration in years Original Price of the Bond Change in the Interest…