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					                                         CHAPTER 10

       THE INVESTMENT FUNCTION IN BANKING AND FINANCIAL SERVICES
                            MANAGEMENT



Goal of This Chapter: The purpose of this chapter is to discover the types of securities that
financial institutions acquire for their investment portfolio and to explore the factors that a
manager should consider in determining what securities a financial institution should buy or sell.

                                   Key Topics in This Chapter

                  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

                                         Chapter Outline

I.      Introduction: The Roles Performed by Investment Securities in Bank Portfolios
II.     Investment Instruments Available to Banks and Other Financial Firms
III.    Popular Money-Market Instruments
        A.     Treasury Bills
        B.     Short-Term Treasury Notes and Bonds
        C.     Federal Agency Securities
        D.     Certificates of Deposit
        E.     International Eurocurrency Deposits
        F.     Bankers' Acceptances
        G.     Commercial Paper
        H.     Short-Term Municipal Obligations
IV.     Popular Capital Market Instruments
        A.     Treasury Notes and Bonds
        B.     Municipal Notes and Bonds
        C.     Corporate Notes and Bonds
III.    Other Investment Instruments Developed More Recently
        A.     Structured Notes
        B.     Securitized Assets
        C.     Stripped Securities
IV.     Investment Securities Actually Held by Banks




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V.      Factors Affecting the Choice of Investment Securities
        A.     Expected Rate of Return
        B.     Tax Exposure
               1.      The Tax Status of State and Local Government Bonds
               2.      Bank Qualified Bonds
               3.      Tax Swapping Tool
               4.      The Portfolio Shifting Tool
        C.     Interest-Rate Risk
        D.     Credit or Default Risk
        E.     Business Risk
        F.     Liquidity Risk
        G.     Call Risk
        H.     Prepayment Risk
        I.     Inflation Risk
        J.     Pledging Requirements
VI.     Investment Maturity Strategies
        A.     The Ladder or Spaced-Maturity Policy
        B.     The Front-End Load Maturity Policy
        C.     The Back-End Load Maturity Policy
        D.     The Barbell Strategy
        E.     The Rate Expectations Approach
VII.    Maturity Management Tools
        A.     The Yield Curve
        B.     Duration
VIII.   Summary of the Chapter

                                         Concept Checks

10-1. Why do banks and institutions choose to devote a significant portion of their assets to
investment securities?

Investments perform many different roles that act as a necessary complement to the advantages
loans provide. Investments generally have less credit risk than loans, allow the bank or thrift
institution to diversify into different localities than most of its loans permit, provide additional
liquid reserves in case more cash is needed, provide collateral as called for by law and regulation
to back government deposits, help to stabilize bank income over the business cycle, and aid
banks in reducing their exposure to taxes.

10-2. What key roles do investments play in the management of a bank or other depository
institution?

See answer to 10-1

10-3. What are the principal money market and capital market instruments available to
institutions today? What are their most important characteristics?




                                                129
Banks purchase a wide range of investment securities. The principal money market instruments
available to banks today are Treasury bills, federal agency securities, CD's issued by other
depository institutions, Eurodollar deposits, bankers' acceptances, commercial paper, and short-
term municipal obligations. The common characteristics of most these instruments is their safety
and high marketability. Capital market instruments available to banks include Treasury notes and
bonds, state and local government notes and bonds, mortgage-backed securities, and corporate
notes and bonds. The characteristics of these securities is their long run income potential.

10-4. What types of investment securities do banks prefer the most? Can you explain why?

Commercial banks clearly prefer these major types of investment securities: United States
Treasury securities, federal agency securities, and state and local government (municipal) bonds
and notes. They hold small amounts of equities and other debt securities (mainly corporate notes
and bonds). They pick these types because they are best suited to meet the objectives of a banks
investment portfolio, such as tax sheltering, reducing overall risk exposure, a source of liquidity
and naturally generating income as well as diversifying their assets.

10-5. What are securitized assets? Why have they grown so rapidly in recent years?

Securitized assets are loans that are placed in a pool and, as the loans generate interest and
principal income, that income is passed on to the holders of securities representing an interest in
the loan pool. These loan-backed securities are attractive to many banks because of their higher
yields and frequent federal guarantees (in the case, for example, of most home-mortgage-backed
securities) as well as their relatively high liquidity and marketability

10-6. What special risks do securitized assets present to institutions investing in them?

Securitized assets often carry substantial interest-rate risk and prepayment risk, which arises
when certain loans in the securitized-asset pool are paid off early by the borrowers (usually
because interest rates have fallen and new loans can be substituted for the old loans at cheaper
loan rates) or are defaulted. Prepayment risk can significantly decrease the values of securities
backed by loans and change their effective maturities.

10-7. What are structured notes and stripped securities? What unusual features do they contain?

Structured notes usually are packaged investments assembled by security dealers that offer
customers flexible yields in order to protect their customers' investments against losses due to
inflation and changing interest rates. Most structured notes are based upon government or
federal agency securities.

Stripped securities consist of either principal payments or interest payments from a debt security.
The expected cash flow from a Treasury bond or mortgage-backed security is separated into a
stream of principal payments and a stream of interest payments, each of which may be sold as a
separate security maturing on the day the payment is due. Some of these stripped payments are
highly sensitive to changes in interest rates.




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10-8. How is the expected yield on most bonds determined?

For most bonds, this requires the calculation of the yield to maturity (YTM) if the bond is to be
held to maturity or the planned holding period yield (HPY) between point of purchase and point
of sale. YTM is the expected rate of return on a bond held until its maturity date is reached,
based on the bond's purchase price, promised interest payments, and redemption value at
maturity. HPY is a rate of discount bringing the current price of a bond in line with its stream of
expected cash inflows and its expected sale price at the end of the bank's holding period.

10-9. 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 $1,000 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 yield be?

The relevant formula is:

             $100          $100         $1000
$950 =                            
         (1  YTM) 1
                       (1  YTM) 2
                                     (1  YTM) 2

Using a financial calculator we get:

YTM = 12.99%

If the bond is sold after one year, the formula entries change to:

             $100          $970
$950 =               
         (1  YTM) 1
                       (1  YTM) 1

and the YTM is:

YTM = 12.63%

10-10. What forms of risk affect investments?

The following forms of risk affect investments: interest-rate risk, credit risk, business risk,
liquidity risk, prepayment risk, call risk, and inflation risk. Interest-rate risk captures the
sensitivity of the value of investments to interest-rate movements, while credit risk reflects the
risk of default on either interest or principal payments. Business risk refers to the impact of
credit conditions and the economy, while liquidity risk focuses on the price stability and
marketability of investments. Prepayment risk is specific to certain types of investments and
focuses on the fact that some loans which the securities are based on can be paid off early. Call
risk refers to the early retirement of securities and inflation risk refers to their possible loss of
purchasing power.




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10-11. How has the tax exposure of various U.S. bank security investments changed in recent
years?

In recent years, the government has treated interest income and capital gains from most bank
investments as ordinary income for tax purposes. In the past, only interest was treated as
ordinary income and capital gains were taxed at a lower rate. Tax reform in the United States
has also had a major impact on the relative attractiveness of state and local government bonds as
bank investments, limiting bankers’ ability to deduct borrowing costs for tax purposes when
borrowing money to buy municipal securities.

10-12. Suppose a corporate bond an investment officer would like to purchase for her bank has a
before-tax yield of 8.98 percent and the bank is in the 35 percent federal income tax bracket.
What is the bond's after-tax gross yield? What after tax rate of return must a prospective loan
generate to be competitive with the corporate bond? Does a loan have some advantages for a
lending institution that a corporate bond would not have?

After-tax Gross Yield on Corporate Bond = 8.98 %( 1 - 0.35) = 5.84%.

A prospective loan must generate a comparable yield to that of the bond to be competitive.
However, granting a loan to a corporation may have the added advantage of bringing in
additional service business for the bank that merely purchasing a corporate bond would not do.
In this case the bank would accept a somewhat lower yield on the loan compared to the bond in
anticipation of getting more total revenue from the loan relationship due to the sale of other bank
services.

10-13. What is the net after-tax return on a qualified municipal security whose nominal gross
return is 6 percent, the cost of borrowed funds is 5 percent, and the bank is in the 35 percent tax
bracket? What is the tax-equivalent gross yield (TEY) on this tax-exempt security?

Net After-Tax Return = (.06 - .05) + (0.35 x 0.80 x .05) = 0.024 or 2.4%

The security's tax-equivalent yield in gross terms is 6 %/( 1-0.35) or 9.23%.

10-14. Spiro Savings Bank currently holds a government bond valued on the day of its purchase
at $5 million, with a promised interest yield of 6-percent, whose current market value is $3.9
million. Comparable quality bonds are available today for a promised yield of 8 percent. What
are the advantages to Spiro Savings from selling the government bond bearing a 6 percent
promised yield and buying some 8 percent bonds?

In this instance the bank could sell the 6-percent bonds, buy the 8 percent bonds, and experience
an extra 2 percent in yield. The bank would experience a capital loss of $1.1 million from the
bond's book value, but the after-tax loss would be only $1.1 million * (1-0.35) or $0.715 million.




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10-15. What is tax swapping? What is portfolio shifting? Give an example of each?

A tax swap involves exchanging one type of investment security for another when it is
advantageous to do so in reducing the bank's current or future tax exposure. For example, the
bank may sell investment securities at a loss to offset high taxable income on loans or to replace
taxable securities with tax-exempt securities. Portfolio switching which involves selling certain
securities out of a bank's portfolio, often at a loss, and replacing them with other securities, is
usually carried out to gain additional current income, add to future income, or to minimize a
bank's current or future tax liability. For example, the bank may shift its holdings of investment
securities by selling off selected lower-yielding securities at a loss, and substituting higher-
yielding securities in order to offset large amounts of loan income.

10-16. Why do depository institutions face pledging requirements when they accept government
deposits?

Pledging requirements are in place to safeguard the deposit of public funds. The first $100,000
of public deposits is covered by federal deposit insurance; the rest must be backed up by bank
holdings of U.S. Treasury and federal agency securities valued at their par values.

10-17. What types of securities are used to meet collateralization requirements?

When a bank borrows from the discount window of its district Federal Reserve bank, it must
pledge either federal government securities or other collateral acceptable to the Fed. Typically,
banks will use U.S. Treasury securities to meet these collateral requirements. If the bank raises
funds through repurchase agreements (RPs), banks must pledge securities, typically U.S.
Treasury and federal agency issues, as collateral in order to borrow at the low RP interest rate.

10-18. What factors affect a financial service institution’s decision regarding the different
maturities of securities it should hold?

In choosing among various maturities of short-term and long-term securities to hold, the
financial institution needs to carefully consider the use of two key maturity management tools -
the yield curve and duration. These two tools help management understand more fully the
consequences and potential impact on earnings and risk of any particular maturity mix of
securities they choose.

10-19. What maturity strategies do financial firms employ in managing their portfolios?

In choosing the maturity distribution of securities to be held in the financial firm’s investment
portfolio one of the following strategies typically is chosen by most institutions:

A.     The Ladder or Spread-Maturity Strategy
B.     The Front-End Load Maturity Strategy
C.     The Back-End Load Maturity Strategy
D.     The Bar Bell Strategy
E.     The Rate-Expectation Approach



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The ladder or spaced-maturity strategy involves equally spacing out a bank's security holdings
over its preferred maturity range to stabilize investment earnings. The front-end load maturity
strategy implies that a bank will pile up its security holdings into the shortest maturities to have
maximum liquidity and minimize the risk of loss due to rising interest rates. The back-end
loaded maturity policy calls for placing all security holdings at the long-term end of the maturity
spectrum to maximize potential gains if interest rates fall and to earn the highest average yields.
In contrast, the bar-bell strategy places a portion of the bank's security holdings at the short-end
of the maturity spectrum and the rest at the longest maturities, thus providing both liquidity and
maximum income potential. Finally, the rate expectations approach calls for shifting maturities
toward the short end if rates are expected to rise and toward the long-end of the maturity scale if
interest rates are expected to fall.

10-20. Bacone National Bank has structured its investment portfolio, which extends out to four-
year maturities, so that it holds about $11 million each in one-year, two-year, three-year and
four-year securities. In contrast, Dunham National Bank and Trust holds $36 million on one-
and two-year securities and about $30 million in 8- to 10-year maturities. What investment
maturity strategy is each bank following? Why do you believe that each of these banks has
adopted the particular strategy it has reflected in the maturity structure of its portfolio?

Bacone National Bank has structured its investment portfolio to include $11 million equally in
each of four one-year maturity intervals. This is clearly a spaced maturity or ladder policy. In
contrast, Dunham National Bank holds $36 million in one and two-year securities and about $30
million in 8 and 10-year maturities, which is clearly a barbell strategy. Dunham National Bank
pursues its strategy to provide both liquidity (from the short maturities) and high income (from
the long maturities), while Bacone National is a small bank that needs a simple-to-execute
strategy.

10-21. How can the yield curve and duration help an investment officer choose which securities
to acquire or sell?

Yield curves possibly provide a forecast of the future course of short-term rates, telling us what
the current average expectation is in the market. The yield curve also provides an indication of
equilibrium yields at varying maturities and, therefore, gives an indication if there are any
significantly underpriced or overpriced securities. Finally, the yield curve's shape gives the
bank's investment officer a measure of the yield trade-off - that is, how much yield will change,
on average, if a security portfolio is shortened or lengthened in maturity.

Duration tells a bank about the price volatility of its earning assets and liabilities due to changes
in interest rates. Higher values of duration imply greater risk to the value of assets and liabilities
held by a bank. For example, a loan or security with a duration of 4 years stands to lose twice as
much in terms of value for the same change in interest rates as a loan or security with a duration
of 2 years.




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10-22. A bond currently selling for $950 based on a par value of $1,000 and promises $100 in
interest for three years before being retired. Yields to maturity on comparable-quality securities
are 12 percent. What is the bond’s duration? Suppose interest rates in the market fall to 10
percent. What will be the approximate percent change in the bond’s price?


                              Present        Present
                               Value         Value of         Weight
               Cash           Factor          Cash            Of Each           Duration
 Year          Flow           at 12%          Flow           Cash Flow         Components

   1           $100          0.893          $89.30       (89.30/950)=0.0940     0.0940
   2            100          0.797           79.70       (79.70/950)=0.0839     0.1678
   3           1100          0.712          783.20      (783.20/950)=0.8244     2.4733
                                                                                2.7351 years

Clearly the bond's duration is 2.7351 years. If interest in the market fall to 10 percent, the
approximate percentage change in the bond's price will be:


                                        i
Percentage Change in Price =  D x            x 100%
                                      (1  i)
                                             - .02
                              - 2.7351 x           x 100%  4.884 percent
                                          (1  .12)

                                              Problems

10-1. A 10-year U.S. Treasury bond with a par value of $1000 is currently for $1015 from
various security dealers. The bond carries a 7-percent coupon rate. If purchased today and held
to maturity is its expected yield to maturity?

(Hint - the following relationships can help in solving for the yield:

               If price < par value, then yield > coupon rate;
               If price = par value, then yield = coupon rate;
               If price > par value, then yield < coupon rate.)

Since the bond is selling at a premium, that is, price > par value, the yield will be less than the
coupon rate, or a yield < 7%.




                                                 135
The relevant formula is:

              $70            $70                 $70           $1000
$1015 =                             ...               
          (1  YTM) 1
                        (1  YTM) 2
                                            (1  YTM) 10
                                                           (1  YTM) 10

YTM = 6.79% (using a financial calculator)


10-2. A municipal bond is selling today for $1036.80 and has a $1,000 face (par) value. Its
yield to maturity is 6 percent, and the bond promises its holders $65 per year in interest for the
next 10 years. What is the bond's duration?

              Annual                     PV of            Time                Time-
              Interest       PV         Annual            Period             Weighted
  Year        Income        at 6%       Interest         Recorded              PV

    1        $ 65           0.943        61.32       x      1         =           $61.32
    2        $ 65           0.890        57.85       x      2         =          $115.70
    3        $ 65           0.840        54.58       x      3         =          $163.74
    4        $ 65           0.792        51.49       x      4         =          $205.96
    5        $ 65           0.747        48.57       x      5         =          $242.85
    6        $ 65           0.705        45.82       x      6         =          $274.92
    7        $ 65           0.665        43.23       x      7         =          $302.61
    8        $ 65           0.627        40.78       x      8         =          $326.24
    9        $ 65           0.592        38.47       x      9         =          $346.23
   10        $ 65           0.558        36.30       x     10         =          $363.00
   10        $1000          0.558       558.39       x     10         =         $5583.90
                                       $1036.80                                 $7986.47


Then duration = $ 7986.47 / $1036.80 = 7.703years

10-3. Calculate the yield to maturity of a 10-year U.S. Government bond that is currently
selling for $1050 in today's market and carries an 8-percent coupon rate with interest paid
semiannually.

               $40              $40                   $40             $1000
$1050 =                                 ...                 
          (1  YTM/2) 1
                          (1  YTM/2) 2
                                                (1  YTM/2) 20
                                                                 (1  YTM/2) 20

YTM/2 = 3.64%, YTM = 7.29% (using a financial calculator)




                                                   136
10-4. A corporate bond being seriously considered for purchase by First Security Savings Bank
will mature 20 years from today and promises a 12 percent interest payment once a year. Recent
inflation in the economy has driven the yield to maturity on this bond to 15 percent, and it carries
a face value of $1000. Calculate this bond’s duration.

              Annual               PV of           Time             Time-
              Interest     PV     Annual           Period         Weighted
  Year        Income     at 15%   Interest      X Recorded      =    PV
    1          $120      0.870  $104.40               1             $104.40
    2           120      0.756    90.72               2              181.44
    3           120      0.658    78.96               3              235.88
    4           120      0.572    68.84               4              274.56
    5           120      0.497    59.64               5              298.20
    6           120      0.432    51.84               6              311.04
    7           120      0.376    45.12               7              315.84
    8           120      0.327    39.24               8              313.92
    9           120      0.284    34.08               9              306.72
   10           120      0.247    29.64              10              296.40
   11           120      0.215    25.80              11              283.80
   12           120      0.187    22.44              12              269.28
   13           120      0.163    19.56              13              254.28
   14           120      0.141    16.92              14              236.88
   15           120      0.123    14.76              15              221.40
   16           120      0.017    12.84              16              205.44
   17           120      0.093    11.16              17              189.72
   18           120      0.081      9.72             18              174.96
   19           120      0.070      8.40             19              159.60
   20           120      0.061      7.32             20              146.40
   20          1000      0.061    61.00              20             1220.00
                                 $812.2                           $6001.16
                                       0

Therefore, the bond's duration is: $6001.16/$812.20 = 7.39 years.


10-5. Tiger National Bank regularly purchases municipal bonds issued by small rural school
districts in its region of the state. At the moment, the bank is considering purchasing an $8
million general obligation issue from the Youngstown school district, the only bond issue that
district plans this year. The bonds, which mature in 15 years, carry a nominal annual rate of
return of 7.75%. Tiger, which is in the top corporate tax bracket of 35 percent, must pay an
average interest rate of 7.38% to borrow the funds needed to purchase the municipals. Would
you recommend purchasing these bonds?

         a)     Calculate the net after tax return on this bank qualified municipal security. What
                is the tax advantage for being a qualified bond?




                                                137
       Because these bonds were issued by a small governmental unit issuing less than $10
       million in securities annually, the interest cost the bank has to pay to acquire the funds
       needed to buy these bonds is tax deductible. Therefore, their net after-tax return is:

       Net A.T.R      =       (7.75% - 7.38%) + (0.80 x 0.35 x 7.38%)
                      =       7.75% -7.38% + 2.066%
                      =       2.436%

       This net yield figure should be compared with other investments of comparable risk on an
       after-tax basis. However, the tax-exempt status of the income coupled with the tax-
       deductibility of the interest expense make these bonds a very attractive alternative.

       b)      What is the tax equivalent yield for this bank qualified municipal security?

                 7.75  2.066
       TEY =                  = 15.10%
                    1 .35

10-6. Tiger National Bank also purchases municipal bonds issued by the city of Cleveland.
Currently the bank is considering a nonqualified general obligation municipal issue. The bonds
which mature in 10 years provide a nominal annual rate of return of 8.1 percent. Tiger National
Bank has the same cost of funds and tax rate as stated in the previous problem.

       a.      Calculate the net after tax return on this nonqualified municipal security

               Net A.T.R. = 8.1 – 7.38 = 0.72 percent

       b.      What is the tax equivalent yield for this nonqualified municipal security?
                         .
                       810
               TEY =          = 12.46 percent
                      1 .35

       c.      Discuss the pros and cons of purchasing the nonqualified rather than the bank
               qualified municipal described in the previous problem.

               Clearly, the net after tax return for the nonqualified bond is lower than for the
               qualified bond. On the other hand, smaller municipal bonds are less liquid and
               thus, carry a higher liquidity risk (they also tend to have a higher default risk, but
               that should already be priced into the yield of the bond).


10-7. Lakeway Thrift savings and Trust is interested in doing some investment portfolio
shifting. This institution has had a good year thus far with strong loan demand; its loan revenue
has increased by 16 percent over last year’s level. Lakeway is subject to the 35 percent corporate
income tax rate. The investments officer has several options in the form of bonds that have been
held for some time in its portfolio:




                                                138
       a.     Selling $4 million in 12-year City of Dallas bonds with a coupon rate of 7.5
       percent and purchasing $4 million in bonds from Bexar County (also with 12-year
       maturities) with a coupon rate of 8% and issued at par. The Dallas bonds have a current
       market value of $3,750,000 but are listed at par on the thrift institution’s books

       b.     Selling $4 million in 12-year U.S. Treasury bonds that carry a coupon rate of 12%
       and are recorded at par, which was the price when the bank purchased them. The market
       value of these bonds has risen to $4,330,000.

Which of these two portfolio shifts would you recommend? Is there a good reason for not selling
the Treasury bonds? What other information is needed to make the best decision? Please
explain.

Under Option A Lakeway will take an immediate $4 million - $3.75 million, or $250,000, loss
before taxes (or a loss of $162,500 after taxes) which can be used to help offset the high taxable
loan income earned this year. Moreover, the thrift will be able to earn 8% on an investment of
$4 million, or $320,000, in annual interest income compared to only $300,000 with the bonds
currently held or a gain in tax-exempt income of $20,000 per year. (Of course, if the thrift can
only afford to buy $3,750,000 in new municipals - the sale price of the old bonds - it will
generate about $300,000 in after-tax interest and have no net gain in tax-exempt interest income,
but will still have a tax-deductible loss on the sale of the old bonds.)

Under Option B the U.S. Treasury bonds must be sold for a gain of $330,000 which is taxable
income. Because Lakeway does not need additional taxable income, Option B is less desirable
than Option A. Besides, the Treasury bonds are selling at a premium above par which indicates
their coupon rate is higher than current interest rates on investments of comparable risk,
suggesting the wisdom of retaining these bonds in the bank's portfolio either until loan revenues
decline and the bank needs additional taxable income or until interest rates rise well above
current levels and new securities appear that promise significantly higher interest yields.

10-8. Current market yields on U.S. government securities are distributed by maturity as
follows:

       3-month T bills        =       7.69 percent
       6-month T bills        =       7.49 percent
       1-year T notes         =       7.77 percent
       2-year T notes         =       7.80 percent
       3-year T notes         =       7.80 percent
       5-year T notes         =       7.81 percent
       7-year T notes         =       7.86 percent
       10-year T notes        =       7.87 percent
       30-year T bonds        =       7.90 percent




                                               139
Draw a yield curve for the above securities. What shape does the curve have? What significance
might this yield curve have for an investing institution with 75 percent of its investment portfolio
in 7-year to 30-year Treasury bonds and 25 percent in U.S. government bills and notes under one
year? What would you recommend to management?

The yield curve for U.S. Treasury bonds clearly slopes upward after the 6-month maturity point
and declines for 3- to 6-month maturities. Like most yield curves this curve becomes quite flat at
longer maturities, particularly over the 7- to 30-year maturity segment. A financial institution
with 75 percent of its portfolio in this 7- to 30-year range gains very little yield advantage over
those institutions holding shorter maturities in the form of 3-month bills to 5-year notes. Yet, the
longer-term bonds are less liquid so that a bank holding 7+-year maturities faces substantially
greater liquidity risk. This bank would probably be better off to do some portfolio shifting into
medium-term maturities.

10-9. A bond possesses a duration of 5.82 years. Suppose that market interest rates on
comparable bonds were 7 percent this morning but have now shifted upward to 7.5 percent.
What percentage change in the bond’s value occurred when interest rates moved 0.5 percent
higher?

                                       .005   2.91
 Percent Change in Value =      5.82                 .0272 or 2.72%
                                      1  .07  1.07

10-10. The investment officer for Sillistine Savings is concerned about interest-rate risk
lowering the value of the institution’s bonds. A check of the bond portfolio reveals an average
duration of 4.5 years. How could this bond portfolio be altered in order to minimize interest rate
risk within the next year?

Sillistine’s bond portfolio has an average duration of 4.5 years. This is relatively long,
subjecting them to substantial interest-rate risk. Shortening the duration of the portfolio or the
use of hedging tools (such as futures and options) is recommended.

10-11. A bank’s economic department has just forecast accelerated growth in the economy with
GDP expected to grow at a 4.5 percent annual growth rate for at least the next two years. What
are the implications of this economic forecast for an investment officer? What types of securities
should the investment officer think most seriously about adding to the investment portfolio?
Why? Suppose the bank holds a security portfolio similar to the one described in Table 10-3 for
all insured U.S. banks. Which type of securities might the investments officer want to think
seriously about selling if the projected economic expansion takes place? What losses might
occur and how could these be minimized?




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This economic forecast suggests that the current yield curve should be upward sloping and that
interest rates will rise over the next two years. In addition, loan demand should increase as the
economy expands suggesting that the bank may have to sell some of its investment portfolio in
the future to meet that demand. The investment officer would probably shorten the maturities of
the investment portfolio. An exception to this might be if the investment officer wants to ride the
yield curve by selling shorter term securities at a premium today and replacing them with longer
maturity securities with higher coupon rates. However, the investment manager must take into
account the risk of capital losses for the future with this strategy. The investment manager can
reduce his risks with the appropriate hedging tools as discussed in previous chapters.

10-12. Contrary to the exuberant economic forecast described in problem 11, suppose a bank’s
economic department is forecasting a significant recession in economic activity. Output and
employment are projected to decline significantly over the next 18 months. What are the
implications of this forecast for an investment portfolio manager? What is the outlook for
interest rates and inflation under the foregoing assumption? What types of investment securities
would you recommend during the period covered by the recession forecast and why? What other
kinds of information would you like to have about the bank’s current balance sheet and earnings
report in order to help you make the best quality decisions regarding the bank’s security
portfolio?

This economic forecast suggests that the current yield curve should be flat or downward sloping
and interest rates and inflation should fall over the next 18 months. In addition, loan demand
should decline in the future as output and employment decline. The portfolio manager should
lengthen the maturities of the investment portfolio and lock in higher rates now. However, the
investment manager should look at the bank’s current interest-sensitive gap and duration gap
position as well as their current earnings and tax status and consider these aspects of the bank’s
balance sheet before making any decisions.

10-13. Arrington Hills Savings Bank, a $3.5 billion asset institution, holds the investment
portfolio outlined in the following table. The savings bank serves a rapidly growing money
center into which substantial numbers of businesses are relocating their corporate headquarters.
Suburban areas around the city are also growing rapidly as large numbers of business owners and
managers along with retired professionals are purchasing new homes. Would you recommend
any change in the makeup of this investment portfolio? Please explain why.

                             % of                                       %of
Types of Securities Held     Total     Types of Securities Held         Total

U.S. Treasury Securities     38.70%    Securities Available for Sale    45.60%
Federal Agency Securities    35.20%    Securities, Maturities <1 year   11.30%
State and Locl Govts.        15.50%    One to Five Years                37.90%
Domestic Debt Securities      5.10%    Over Five Years                  50.80%
Foreign Debt Securities       4.90%
Equities                      0.60%




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This bank is going to experience increasing loan demand in the future. This may mean increased
taxes in the future, increased liquidity risk and increased credit risk from its loan portfolio. To
help with the liquidity risk, the bank may want to consider shifting some of its portfolio from
securities with more than five years to maturity to shorter term securities. In terms of the
increased taxes and credit risk, it depends on which one of these is more important. The
proportion of the municipal bonds in this bank’s portfolio is already higher than the average bank
of its size. The bank may want to reduce its credit risk by reducing its municipal bond portfolio.
However, this bank does have other ways of reducing its credit risk and it may want to decrease
its taxability by increasing its investment in municipal bonds.




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