Chapter Ten

The Investment Function in

Financial-Services Management

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 Content
1. Investment functions
2. Investment instruments
3. Factors affecting choice of investment securities
4. Investment maturity strategies

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 WHAT IS INVESTMENT?
• Investment is the commitment of money or
capital to purchase financial instruments or
other assets in order to gain profitable returns
in the form of interest, income or appreciation
of the value of the instrument.

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 10-4

EXHIBIT 10–1 Investments: The Crossroads Account on a

Depository Institution’s Balance Sheet

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 10-6

Investment Instruments Available to Financial

Firms
• The number of financial instruments available for
financial institutions to add to their portfolios is both large
and growing
• Each financial instrument has different characteristics
with regard to expected yields, risk, sensitivity to inflation,
and sensitivity to shifting government policies and
economic conditions
• It is useful to divide them into two broad groups
1. Money market instruments
▫ Reach maturity within one year and are noted for their low risk and
ready marketability
2. Capital market instruments
▫ Have remaining maturities beyond one year and are generally noted
for their higher expected rate of return and capital gains potential
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 10-7

Investment Instruments Available to Financial

Firms (continued)
• Investment security portfolios help to
▫ 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
▫ Provide flexibility
▫ Dress up a bank’s balance sheet

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 10-8

Popular Money Market Investment

Instruments
• 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

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 10-9

Popular Capital Market Investment

Instruments
• Treasury Notes and Bonds
• Municipal Notes and Bonds
• Corporate Notes and Bonds

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 10-10

Investment Instruments Developed More

Recently
• Structured Notes
▫ Arose from security dealers who assembled pools of federal
agency securities and offered investments officers a packaged
investment whose interest yield could be reset periodically
based on what happened to a reference interest rate
• Securitized Assets
▫ Pass-through securities
▫ CMOs The Collateralized Mortgage Obligation
Mortgage-backed bonds
▫ Guarantees from government agencies; higher average yields; lack of
good-quality assets; superior liquidity
• Stripped Securities
▫ Principal-Only (PO) and Interest-Only (IO) securities
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 10-11

Investment Securities Held by Banks

• Just a few types of securities dominate bank investment
portfolios
1. U.S. government (especially Treasury) securities
2. Obligations of various federal agencies such as the
Federal National Mortgage Association (FNMA), the
Federal Home Loan Mortgage Corporation (FHLMC),
and the Government National Mortgage Association
(GNMA), especially in the form of mortgage-backed
securities
3. State and local government obligations (municipals)
4. Nonmortgage-related asset-backed securities (such as
obligations backed by credit card and automobile loans)
5. Equities (common and preferred stock)
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 10-12

TABLE 10–3 Investment Securities Held by FDIC-Insured

Commercial Banks, 2010

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 10-13

Factors Affecting Choice of Investment

Securities
• The principal factors bearing on which investments are
chosen include
1. Expected rate of return
2. Tax exposure
3. Interest rate risk
4. Credit or default risk
5. Business risk
6. Liquidity risk
7. Call risk
8. Prepayment risk
9. Inflation risk
10. Pledging requirements
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 10-14

Factors Affecting Choice of Investment

Securities (continued)
• Expected Rate of Return
▫ Yield to Maturity (YTM) versus Holding Period Yield
(HPY)
▫ Example
▫ An investments officer is considering purchasing a $1,000 par-
value Treasury note that promises an 8 percent coupon rate and
matures in five years with a current of $900

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Factors Affecting Choice of Investment

Securities (continued)
▫ To evaluate the attractiveness of municipals, financial firms
calculate the net after-tax returns and/or the tax-equivalent
yields to enable comparisons with other investment
alternatives

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 10-16

Factors Affecting Choice of Investment

Securities (continued)
• 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

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Factors Affecting Choice of Investment

Securities (continued)
• Credit or Default Risk
▫ The risk that the security issuer may default on the
principal or interest owed
▫ Three major credit ratings agencies
1. Moody’s
2. Standard & Poor’s
3. Fitch’s Rating Service

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 10-18

TABLE 10–4 Default Risk Ratings on Marketable Investment

Securities (including long-term corporate obligations)

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 10-19

Factors Affecting Choice of Investment

Securities (continued)
• Business Risk
▫ Risk that the economy of the market area the financial
institution serves may slow down
▫ Security portfolio can offset this risk
▫ Securities can be purchased from outside the market
area served
• Liquidity Risk
▫ Can a security be converted into cash quickly and easily
without significant loss in value?
▫ A key issue – the breadth and depth of a security’s resale
market
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Factors Affecting Choice of Investment

Securities (continued)
• Call Risk
▫ Many corporations and some governments that issue
securities reserve the right to call in instruments in
advance of maturity and pay them off
▫ Because such calls usually take place when market
interest rates have declined (and the borrower can get
lower interest costs), the financial firm investing in
callable securities runs the risk of an earnings loss
because it must reinvest its recovered funds at lower
interest rates

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 10-21

Factors Affecting Choice of Investment

Securities (continued)
• Prepayment Risk
▫ A form of risk specific to asset-backed securities
▫ This form of risk arises because the realized interest and
principal payments from a pool of securitized loans may
be quite different from the cash flows expected
originally
▫ Variations in cash flow to holders of the securities
backed by these loans can arise from
1. Loan refinancings
2. Turnover of the assets behind the loans

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 10-22

Factors Affecting Choice of Investment

Securities (continued)
• Prepayment Risk
▫ This means that the market value of a loan-backed
security depends not only upon the promised cash flows
it will generate, but also on the projected prepayments
and loan defaults that occur

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 10-23

Factors Affecting Choice of Investment

Securities (continued)
• Inflation Risk
▫ Purchasing power from a security or loan may be eroded
by rising prices
▫ Recently developed inflation risk hedge – Treasury
Inflation Protected Securities (TIPS)
▫ Both coupon payments and principal adjusted annually for
inflation based on Consumer Price Index
▫ TIPS do not protect investors from all the effects of inflation,
such as moving into higher tax brackets
▫ Carry market risk like regular bonds
▫ Tend to be less liquid

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 10-24

Factors Affecting Choice of Investment

Securities (continued)
• Pledging Requirements
▫ Depository institutions in the United States cannot
accept deposits from federal, state, and local
governments unless they post collateral acceptable to
these governmental units
▫ State and local government deposit pledging
requirements differ widely from state to state, though
most allow a combination of federal and municipal
securities to meet government pledging requirements
▫ If a financial institution uses repurchase agreements
(RPs) to raise money, it must pledge some of its
securities (usually Treasury and federal agency issues) as
collateral in order to receive funds at the lowest RP rate
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 10-25

Investment Maturity Strategies

• The Ladder or Spaced-Maturity Policy
• The Front-End Load Maturity Policy
• The Back-End Load Maturity Policy
• The Barbell Strategy
• The Rate Expectation Approach

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 10-26

EXHIBIT 10–2 Alternative Maturity Strategies for Managing

Investment Portfolios

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EXHIBIT 10–2 Alternative Maturity Strategies for Managing

Investment Portfolios

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EXHIBIT 10–2 Alternative Maturity Strategies for Managing

Investment Portfolios

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EXHIBIT 10–3 Additional Maturity Strategies for Managing

Investment Portfolios

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EXHIBIT 10–3 Additional Maturity Strategies for Managing

Investment Portfolios

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Maturity Management Tools

• The Yield Curve
▫ Picture of how market interest rates differ across
various maturities
▫ Constructed most easily with Treasury securities
▫ Provides information about under and over priced
securities
▫ Provides information about the risk-return trade-off
• Duration
▫ Present value weighted average maturity of the cash
flows
▫ Can be used to insulate the securities from interest rate
changes
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EXHIBIT 10–4 The Yield Curve

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Maturity Management Tools (continued)

• Immunization
▫ Duration also suggests a way to minimize damage to an
investing institution’s earnings that changes in market
interest rates may cause
▫ Duration gives the investments officer a tool to reduce his or
her institution’s exposure to interest rate risk

▫ Portfolio immunization is protecting securities purchased

from loss of return, no matter which way interest rates go
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 10-34

Quick Quiz
• Why do banks and other institutions choose to devote a
significant portion of their assets to investment securities?
• What are the principal money market and capital market
instruments available to institutions today?
• What types of investment securities do banks seem to prefer the
most? By size of institutions? Explain.
• 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 $1000 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 return be?
• How can the yield curve and duration help an investment officer
choose which securities to acquire or sell?
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