Chapter -10

Nature and function of investment

Investment securities available: Advantage and disadvantage
Measuring expected return
Taxes, Credit and Interest- Rate Risks
Liquidity, Prepayment, and other Risks
Investment Maturity Strategies
Maturity Managing tools

To examine the different investment vehicles

available, it is useful to divide them into two board
groups :

(1) Money Market investment

(2) Capital market instrument

Treasury Bills : T-bills are issued in weekly and

monthly auctions and are particularly attractive to
financial firms because of their high degree of safety.

Short-Term Treasury Notes and Bonds: Treasury

Notes and Bonds have relatively long original
maturities: 1 to 10 years for notes over 10 years for
bonds.

Federal Agency Securities : Marketable notes and bonds

sold by agencies owned by or sponsored by the federal
government are known as federal agency securities.

Certificates of deposit : A certificate of deposit is simply

an interest-bearing receipt for the deposit of funds in a
depository institution.

International Eurocurrency Deposit : Eurocurrency

deposits are time deposits of fixed maturity issued by the
worlds largest banks headquartered in financial centers
around the globe, through the heart of the Eurocurrency
market in London.

Bankers Acceptances : Bankers acceptances are

considered to be among the safest of all money market
instruments.

Commercial Paper : Commercial Paper- short-term,

unsecured IOUs offered by major corporations- an attractive
investment that is safer than most types of loan.

Short-Term Municipal obligation : State and local

government- including countries, cities and special districtsissue a wide variety of short term debt instruments to cover
temporary cash shortages.

Treasury Notes and Bonds : Among the safest and

most liquid assets that investing instruments can buy
are U.S Treasury notes and bonds.

Municipal Notes and Bonds : Long term debt and

obligations issued by states, cities and other
government units are known collectively as
municipal bonds.

Corporate Notes and Bonds : Long-Term debt securities

issued by corporations are usually called corporate notes
when they mature within five years or corporate bonds
when they carry longer maturities.

Structured Notes: A guaranteed floor rate and cap rate

may be added in which the investment return could not
drop below a stated (floor) level or rise above some
maximum level.

Securitized Assets : Securitized Assets are backed by

selected loans of uniform type and quality, such as
FHA and VA insured home mortgages and credit card
loans.

Stripped Securities : In the early 1980s, security dealers

developed a hybrid instrument known as the stripped
security. A claim against either the principal or interest
payments associated with a debt security, such as Treasury
bond.

Clearly just a few types of securities dominate bank

investment portfolios :
1.Obligations of the U.S government and of various federal
agencies such as the Federal National Mortgage Association
(FNMA), the Federal Home Loan Mortgage Corporation
(FHLM), and the Government National Mortgage
Association.
2.State and local government obligations (municipal).
3.Nonmortgage-related asset-backed securities (such as
obligations backed by credit card and automobile loans).

1. Expected Rate of return : The investment officer

must determine the total rate of return that can
reasonably be expected from each security, including
the interest payments promised and possible capital
gains or losses.

It the T-notes current price is 900$, we have

$80
$80
$80
$1000
$900=
+
+
+
(1+YTM)1 (1+YTM)2
(1+YTM)5 (1+YTM)5

$80
$900=

$80

$950

+
+
(1+HPY)1 (1+HPY)2 (1+HPY)2

2. Tax Exposer : Interest and capital gains income most

investment held by U.S banks are taxed as ordinary income
for tax purpose, just are the wages and salaries earned by U.S
citizens.
The

tax status and local government bonds : For banks in the upper tax brackets, taxexempt state and local government (municipal) bonds and notes have been attractive
from time to time, depending upon their status in tax law.
For example, suppose that Aaa-rated corporate bonds are carrying an average gross
yield to maturity of 7 percent, the prime rate on top-quality corporate loans is 6
percent, and Aaa-rated municipal bonds have a 5.5 percent gross yield to maturity. The
investment officer for a financial firm subject to the corporate income tax could
compare each of these potential yields using this formula :

Before tax gross yield (1-Firms marginal income tax rate) =

After Tax gross yield.

The impact of changes in tax laws : Tax reform in the

United states has had a major impact on the relative
attractiveness of state and local government bonds as
investment for banks.
Bank Qualified Bonds : Before 1986 the federal tax code
allowed significant tax deduction for interest expanses
incurred when banks fund to buy municipal securities.
The tax swapping tools : In tax swap the lending
institution sells lower-yielding securities at a loss in order to
reduce its current taxable income, while simultaneously
purchasing new high yielding securities in order to boost
future returns on its investment portfolio.

The portfolio shifting tools : Lending intuitions also do a

great deal of portfolio shifting in their holdings of investment
securities, with both taxes higher returns in mind.

3. Interest rate risk: A growing number of tools to hedge

(counteract) interest rate risk have appeared in recent years,
including financial futures, options, interest-rate swaps, gap
management and duration.
4. Credit or Default Risk : The investment made by banks and
their closest competitors are closely regulated due to the credit
risk displayed by many securities, especially those issued by
private corporations and some governments.

5. Business risk : These adverse developments often called

business risk can be reflected quickly in the loan portfolio
where delinquent loans may rise as borrowers struggle to
generate enough cash flow to pay the lender.
6. Liquidity risk: Financial institution must be ever mindful of
the possibility they will be required to sell investment in
advance of their maturity due to liquidity needs and be
subjected to liquidity risk.
7. Call risk: Investment officer generally try to minimize this
call risk by purchasing callable instrument bearing longer call
deferment or simply by avoiding the purchase of callable
securities.
8. Prepayment risk: A form risk specific to asset backed
securities is prepayment risk.

9. Inflation risk : Some protection against inflation risk is

provided by short term securities and those with variable
interest rates, which usually grant the investment officer
greater flexibility in responding to any flare up in
inflationary pressure.
10. Pledging Requirement : State and local government
deposit pledging requirements differ widely from state to
state through most allow a combination of federal and
municipal securities to meet government pledging
requirement.

The ladder or spaced maturity policy: One popular

approach to the maturity problem, particularly among
smaller institutions is to choose some maximum acceptable
maturity and then invest in an equal proportion of securities
in each of several maturity intervals until the maximum
acceptable maturity is reached.
The front end load maturity policy: Another popular
strategy is to purchase only short-term securities and place
all investment within a brief interval of time.
The back end load maturity policy : An opposite approach
would stress the investment portfolio as a source of income.

The barbell strategy : A combination of the front-end and back-end

load approaches is the barbell strategy in which an investing
institution places most of its funds in a short-term portfolio of highly
liquid securities at one extreme and in a long-term portfolio of highly
liquid securities at one extreme and in long term portfolio of bonds at
the other extreme, with minimal investment holdings in intermediate
maturities.
The rate expectation approach : The most aggressive of all maturity
strategies is one that continually shifts maturities of securities in line
with current forecast of interest rates and the economy.

The Yield curve : The yield curve is simply a picture

of how market interest rates differ across loans and
securities of varying term to maturity.