1. The Investment Function in Financial-Services Management
Chapter Ten
The Investment Function in Financial-Services Management
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Key Topics Functions of investments Investment securities available
10-2
Key Topics
Functions of investments
Investment securities available
Risks in security investments
Investment maturity strategies

3. Functions of a Bank’s Security Portfolio
10-3
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

4. Functions of a Bank’s Security Portfolio
Cash
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
Investments
Non-deposit borrowings
Sell investments when loan demand is high
Add to investments when loan demand is low
Loans

5. Instruments Available to Financial Firms
10-5
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

6. 10-6

7. Money Market Instruments Used by a Bank
10-7
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

8. Capital Market Instruments
10-8
Capital Market Instruments
Treasury notes and bonds over one year to maturity
Municipal notes and bonds
Corporate notes and bonds
Asset backed securities

9. Dominant Investments Held By Banks in 2007
10-9
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

10. Dominant Investments Held By Banks in 2007
Types of securities held
Smallest banks
Medium-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
0.3
5.3
Other domestic debt securities
2.9
12.2
Foreign debt securities
0.1
7.7
Equity securities
0.8
1.1 1
Total investment securities
100

11. Factors Affecting the Choice of Securities
10-11
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

12. 10-12
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

13. 10-13
Default Risk

14. 10-14
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

15. Liquidity Risk Breadth and depth of secondary market
10-15
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

16. 10-16
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

17. Prepayment Risk Specific to asset-backed securities
10-17
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

18. 10-18
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

19. Pledging Requirements
10-19
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

20. Investment Maturity Strategies
10-20
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