INVESTMENT MANAGEMENT OF BANKS

OBJECTIVES Stabilize Bank’s Income Offset Credit Risk Exposure Usage as Collateral Flexible Asset Composition Enhance Liquidity

PORTFOLIO INVESTMENT When deposits are low and loan demand is high –Use investments as collateral and borrow and utilize this to meet loan demand –Sell investments to meet loan demand

PORTFOLIO INVESTMENT When deposits are high and loan demand is weak –Use investments to increase earnings capacity of banks –Retrieve pledged investments to convert it into an earning asset

FACTORS AFFECTING PORTFOLIO INVESTMENT Return Risk Tax

INVESTMENT PORTFOLIO OF A BANK Continued.. IInvestments in India in Government Securities ,10, ,26,29 Other approved securities4194,47,614527,26,17 Shares901,89,75992,52,85 Debentures and Bonds15874,94, ,26,61 Subsidiaries and/or joint ventures1436,03,941189,49,38 Others (Units / Commercial Papers etc.) 1538,90,231282,79,48 TOTAL181684,36, ,60,78

INVESTMENT PORTFOLIO OF A BANK IIInvestments outside India in Government securities (including local authorities) 202,93,60381,38,12 Subsidiaries and/or joint ventures abroad 276,73,05216,32,44 Other investments (Shares, Debentures etc.) 3512,45,423864,59,38 GRAND TOTAL3992,12,074462,29,94 Reference:

INVESTMENTS OF SCHEDULED COMMERCIAL BANKS Continued.. (Amount in Rs. crore) ItemsAs on March 31 Year 1Year 2Year 3 Amount share Per cent Amount share Per cent Amount share Per cent (1)(2)(3)(4)(5)(6) Investments by offices in India A.Indian Government Securities Central Government State Governments Others *

INVESTMENTS OF SCHEDULED COMMERCIAL BANKS Continued.. (Amount in Rs. crore) ItemsAs on March 31 Year 1Year 2Year 3 Amount share Per cent Amount share Per cent Amount share Per cent B. Other domestic securities, bonds, shares, etc. 1 Other trustee securities (excluding units of UTI) 2 Fixed Deposits Shares and Debentures of Joint Stock Companies (market value)

INVESTMENTS OF SCHEDULED COMMERCIAL BANKS Continued.. (Amount in Rs. crore) ItemsAs on March 31 Year 1Year 2Year 3 Amount share Per cent Amount share Per cent Amount share Per cent 4Initial contribution to Share Capital of UTI 5Units of UTI Certificate of Deposits and Commercial Papers 7Mutual Funds

INVESTMENTS OF SCHEDULED COMMERCIAL BANKS Continued.. (Amount in Rs. crore) ItemsAs on March 31 Year 1Year 2Year 3 Amount share Per cent Amount share Per cent Amount share Per cent C. Foreign Securities Foreign Governments’ —0 Securities 2Other Foreign Investments

INVESTMENTS OF SCHEDULED COMMERCIAL BANKS Continued.. Amount in Rs. Crore ItemsAs on March 31 Year 1Year 2Year 3 Amount share Per centAmount share Per centAmount share Per cent Investments by Foreign Offices of Indian Banks 1 Indian Securities00—0—0 2 Foreign Countries Securities Other Investments Total

INVESTMENT PERFORMANCE OF BANKS Continued.. (in per cent) As on March 31 Ratios State Bank of India State Bank of Bikaner & Jaipur State Bank of Hyderabad State Bank of Indore Year 1Year 2Year 1Year 2Year 1Year 2Year 1Year 2 Investment- deposit ratio Return on investments Return on investments adjusted to cost of funds

INVESTMENT PERFORMANCE OF BANKS Continued.. (in per cent) As on March 31 Ratios State Bank of Mysore State Bank of Patiala State Bank of Saurashtra State Bank of Travancore Year 1Year 2Year 1Year 2Year 1Year 2Year 1Year 2 Investment- deposit ratio Return on investments Return on investments adjusted to cost of funds

INVESTMENT PERFORMANCE OF BANKS Continued.. (in per cent) As on March 31 Ratios Allahabad Bank Andhra BankBank of Baroda Bank of India Year 1Year 2Year 1Year 2Year 1Year 2Year 1Year 2 Investment- deposit ratio Return on investments Return on investments adjusted to cost of funds

INVESTMENT PERFORMANCE OF BANKS Continued.. (in per cent) As on March 31 Ratios Bank of Maharashtra Canara BankCentral Bank of India Corporation Bank Year 1Year 2Year 1Year 2Year 1Year 2Year 1Year 2 Investment- deposit ratio Return on investments Return on investments adjusted to cost of funds

INVESTMENT PERFORMANCE OF BANKS Continued.. (in per cent) As on March 31 Ratios Dena Bank IDBI Ltd.Indian BankIndian Overseas Year 1Year 2Year 1Year 2Year 1Year 2Year 1Year 2 Investment- deposit ratio Return on investments Return on investments adjusted to cost of funds

INVESTMENT PERFORMANCE OF BANKS Continued.. (in per cent) As on March 31 Ratios Oriental Bank Punjab & Sind Bank Punjab National Bank Syndicate Bank Year 1Year 2Year 1Year 2Year 1Year 2Year 1Year 2 Investment- deposit ratio Return on investments Return on investments adjusted to cost of funds

INVESTMENT PERFORMANCE OF BANKS Continued.. (in per cent) As on March 31 Ratios UCO Bank Union Bank of India United Bank of India Vijaya Bank Year 1Year 2Year 1Year 2Year 1Year 2Year 1Year 2 Investment- deposit ratio Return on investments Return on investments adjusted to cost of funds

INVESTMENT PERFORMANCE OF BANKS Continued.. (in per cent) As on March 31 Ratios ABN Amro Bank Abu Dhabhi Bank American Express Bank Antwerp Diamond Bank Year 1Year 2Year 1Year 2Year 1Year 2Year 1Year 2 Investment- deposit ratio Return on investments Return on investments adjusted to cost of funds

YIELD CURVE Yield curve is a graph that depicts the relationship between bond yields and maturities. Investors use the yield curve as a reference point for forecasting interest rates, pricing bonds and creating strategies for increasing total returns. Yield curve is a leading indicator of economic activity.

CONTENTS OF THE YIELD CURVE Yield on a bond is based on both the purchase price of the bond and the interest or coupon payments received. Yield curve is a line graph that plots the relationship between yields to maturity and time to maturity for bonds of the same asset class and credit quality. The plotted line begins with the spot interest rate, which is the rate for the shortest maturity, and extends out in time, typically to 30 years.

ZERO COUPON YIELD CURVE Maturity in years Source: “ Source: accessed on 15 December 2010.

IMPLICATIONS OF RATE OF INTEREST Yield curve depicts yield differences or yield spreads, that are due to differences in maturity. This relationship between yields and maturities is known as the term structure of interest rates. The normal shape or slope of the yield curve is upward, which means that bond yields usually rise as maturity extends.

THEORIES ON YIELD CURVE Pure Expectations Theory: The theory holds that the slope of the yield curve reflects only investors’ expectations for future short-term interest rates. Mostly investors expect interest rates to rise in the future, which accounts for the usual upward slope of the yield curve. Continued..

THEORIES ON YIELD CURVE Liquidity Preference Theory: Here long-term interest rates not only reflect investors’ assumptions about future interest rates but also include a premium for holding long-term bonds, called the term premium or the liquidity premium. This premium compensates investors for the added risk of having their money tied up for a longer period. Because of the term premium, long-term bond yields tend to be higher than short- term yields, and the yield curve slopes upward. Continued..

THEORIES ON YIELD CURVE Preferred Habitat Theory: In addition to interest rate expectations, investors have distinct investment horizons and require a meaningful premium to buy bonds with maturities outside their preferred maturity or habitat. Proponents of this theory believe that short-term investors are more prevalent in the fixed-income market and therefore, longer-term rates tend to be higher than short-term rates.

SHARP UPWARD YIELD CURVE A sharply upward sloping or steep yield curve, has often preceded an economic upturn. The assumption behind a steep yield curve is interest rates will begin to rise significantly in the future. Investors demand more yield as maturity extends if they expect rapid economic growth because of the associated risks of higher inflation and higher interest rates.

FLAT YIELD CURVE A flat yield curve signals an economic slowdown. The curve flattens when the interest rates rise to restrain a rapidly growing economy. Short-term yields rise to reflect the rate hikes, while long- term rates fall as expectations of moderate inflation prevails. A flat yield curve is unusual and indicates a transition to either an upward or downward slope.

INVERTED YIELD CURVE An inverted yield curve can signal recession. When yields on short-term bonds are higher than those on long-term bonds, it suggests that investors expect interest rates to decline in the future, usually in conjunction with a slowing economy and lower inflation.

YIELD CURVE

Future short-term interest rates will be higher. Investment managers will use this information by shifting their investments away from long-term securities and towards short-term securities.

YIELD CURVE Future short-term interest rates will be lower. Investment managers will use this information by shifting their investments away from short-term securities and towards long-term securities.

RIDING THE YIELD CURVE When the yield curve slopes upward, as a bond approaches maturity or “rolls down the yield curve”, it is valued at successively lower yields and higher prices. Using this strategy, a bond is held for a period of time as it appreciates in price and is sold before maturity to realize the gain. As long as the yield curve remains normal or in an upward slope, this strategy can continuously add to total return on a bond portfolio.

INVESTMENT MATURITY STRATEGIES Ladder or Spaced Maturity Policy Front end Load Maturity Policy Back end Load Maturity Policy Barbell Investment Portfolio Strategy Rate Expectations Strategy

LADDER OR SPACED MATURITY POLICY

Equal percentage of investments over short and long term maturing securities Difficulty in finding good credit rated securities in all maturity profiles Cost of building the investment policy is high

FRONT END LOAD MATURITY POLICY

All investments are made in short-term maturity securities Persistent revision of portfolio is required Policy will be successful only in liquid markets

BACK END LOAD MATURITY POLICY

All investments are long-term maturity securities Policy is subject to price and rate sensitiveness Inflation risk is also to be borne by this policy

BARBELL INVESTMENT PORTFOLIO STRATEGY

A balanced holing of short and long term maturity securities. A bond investment strategy in which the maturities of the securities included in the portfolio are concentrated at two extremes. Barbell strategy involves selecting only bonds with short and long term maturities. The maturity structure of the portfolio can be lengthened or shorted by varying the amount of securities on either end of the maturity range.

BARBELL INVESTMENT PORTFOLIO STRATEGY Using this approach requires constant attention from the portfolio manager. Bonds with short maturities need to be rolled over into new short term securities as they reach maturity. As long term bonds reach middle maturity, they have to be rolled over into new long term securities. One disadvantage to a barbell strategy is its transaction costs. In addition, long term bonds are much more sensitive to interest rate changes. Therefore, the long term maturity side of the portfolio tends to have greater volatility than the short term maturity side.

ACTIVE INVESTMENT STRATEGIES Speculative strategies –Bond Swaps Rate Anticipation Swaps, Quality Swaps, Yield Pick-Up Swaps. –Yield Curve Strategies. Shift Strategies –Ladder Strategy –Bullet Strategy –Barbell Strategy

RATE EXPECTATIONS STRATERGY

RATE EXPECTATION Strategy of buying bonds with high or low durations based on the expectation of an upward or downward parallel shift in the yield curve. It is a type of yield curve shift strategy. Expected in interest rates - Buy Short duration Investments Expected in interest rates - Buy Long duration Investments

QUALITY SWAPS Strategy of buying investments with high or low quality rating based on the expectation of a change in economy. Expect Economic Recession – Buy High quality investments; Sell low quality investments Expect Economic Expansion – Buy low quality investments; Sell high quality investments

YIELD PICK UP SWAP Strategy of identifying investments which are identical but do not yield the same rates. The assumption is that the return on the investments will eventually converge. Among identical investments (same quality, same maturity) Buy the under priced security Sell the overpriced security

TYPES OF YIELD CURVE SHIFTS Parallel Shifts: Rates on all maturities change by the same number of basis points (or by the same percentage). Flattened Twisting: The difference in the yield to maturity of long term instruments to the yield to maturity of short term instruments are declining (YTM LT – YTM ST ). Steeped Twisting: The difference in the yield to maturity of long term instruments to the yield to maturity of short term instruments are increasing (YTM LT – YTM ST ).

TYPES OF YIELD CURVE SHIFTS Positive Humped Shift: Short term and long term rates change more than intermediate interest rates. Negative Humped Shift: Intermediate maturity interest rates change more than short term and long term rates of interest.

BULLET STRATEGY Portfolio of investments concentrated in one maturity area. All investments are heaped as a 5 year or a 3 year or any other specific maturity investment or around this short or long term maturity. Example: 40% of the investment portfolio would have 4.5 years as maturity, 35% would have a maturity of 5 years and the remaining 25% of the investment portfolio would be having a maturity of 5.5 years.

TOTAL RETURN ANALYSIS Total return analysis involves determining the possible returns from different yield curve strategies given different yield curve shifts.

CASE ANALYSIS Consider three bonds: –Investment A: 5-year, 8% bond selling at par. –Investment B:15-year,10% bond selling at par. –Investment C: 10-year, 9% bond selling at par. Two Possible Strategies: –Barbell: Invest 50% in A and 50% in B. –Bullet: 100% in Bond C.

YIELD CURVE SHIFTS Case 1 : Parallel Shifts –A rate change of 50 basis points Case 2: Flattened Twist –C increases by 25 points, A increases by 50 basis points and B increases by 10 basis points Case 3: Steep Twist –C increases by 25 points, A increases by 10 basis points and B increases by 50 basis points Case 4: Positive Hump –C increases by 25 basis points, A and B increases by 50 basis points Case 5: Negative Hump –A and B increases by 25 basis points, C increases by 50 basis points

COMPUTATION OF CASE 1 Investment A Time12345 Interest Rate Total Value Discount at changed rate Discounted Value Interest Income0.085 Asset Appreciation/Depreciation(Value-100)/ Total Return

RETURN ANALYSIS Case 1ACBBulletBarbell Rates Value Return Case 2ACB Rates Value Return Continued..

RETURN ANALYSIS Case 3ACBBulletBarbell Rates Value Return Case 4ACB Rates Value Return Continued..

RETURN ANALYSIS Case 5ACBBulletBarbell Rates Value Return

INTEREST RATES RISE Case 1ACBBulletBarbell Rates Value Return Case 2ACB Rates Value Return Continued..

INTEREST RATES RISE Case 3ACBBulletBarbell Rates Value Return Case 4ACB Rates Value Return Continued..

INTEREST RATES RISE Case 5ACBBulletBarbell Rates Value Return

TOTAL RETURN ANALYSIS Parallel Shifts: –For rate increases, the barbell strategy gives best results. –For rate declines the bullet strategy gives best results. Flattening: –For rate increases, the barbell strategy gives best results. –For rate declines the bullet strategy gives best results. Steepening: –For rate increases, the bullet strategy gives best results. –For rate declines the barbell strategy gives best results. Continued..

TOTAL RETURN ANALYSIS Positive Hump: –For rate increases, the bullet strategy gives best results. –For rate declines the barbell strategy gives best results. Negative Hump: –For rate increases, the barbell strategy gives best results. –For rate declines the bullet strategy gives best results.