MANAGING BANKS’ INVESTMENT

Previous Lessons

 Banks and Financial Services

 Financial Statements of Banks
 Evaluating Bank Performance
 Liquidity and Reserve Management

Key Terms

 Capital/money market: Thị trường vốn/tiền tệ

 Treasury bonds/notes/bills: Trái phiếu/kỳ phiếu/tín phiếu
Chính phủ/Kho bạc
 Municipal bonds: Trái phiếu chính quyền địa phương (bang)
 Yield to maturity (YTM): Tỷ lệ lãi suất đáo hạn
 Holding period yield: Tỷ lệ lãi suất nắm giữ
 Pledging: Đặt cọc
 Yield curve: Đường cong lãi suất
 Securities/Financial Instruments/Assets: Chứng
khoán/Công cụ/Tài sản tài chính
3

1
 Learning Objectives

 Reasons for banks’ investment

 Types of financial markets
 Types of banks’ investing securities
 Factors affecting bank investment
decisions
 Investment maturity strategies
 Maturity management tools
4

WHY DO BANKS INVEST IN SECURITIES??

Main reasons for banks’ securities investment

REASONS FOR BANKS’ INVESTMENT

 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
6

2
 Financial markets are a system that includes
individuals and institutions, instruments, and
procedures that bring together borrowers
and savers no matter the location

 Primary versus secondary markets

 Physical vs. OTC market

 Debt versus equity markets

 Money versus capital markets

 The secondary market - trading in the outstanding,

previously issued shares of established, publicly
owned companies
 The primary market - additional shares sold by
established, publicly owned companies
 IPO market - new public offerings by privately held
firms

3
 Physical stock exchanges
 NYSE, AMEX, and regional
exchanges
 Exchange members
 Floor brokers
 Specialists
 To have a stock listed
 Apply to the exchange
 Pay a relatively small fee
 Meet the exchange’s minimum
requirements

10

 Over-the-Counter Markets and the Nasdaq

 Network of brokers and dealers
 Auction market
 Organized Investment Network
 Electronic Communications Networks

11

12

4
Debt Characteristics
 Principal Value, Face Value,
Maturity Value, and Par
Value
 Interest Payments
 Maturity Date
 Priority to Assets and
Earnings
 Control of the Firm

13

Types of Short term Debt

 Treasury Bills
 Discounted securities issued by U.S. government to finance
operations
 Repurchase Agreement
 One bank sells financial assets to another banks with the promise to
repurchase the securities later at a higher price
 Federal Funds
 Overnight loans from one bank to another

14

Types of Short term Debt

 Commercial Paper
 A type of promissory note issued by large financially sound firms
 Certificate of Deposit
 Represents a time deposit at a bank or other financial intermediary
 Eurodollar Deposit
 A deposit in a bank outside the U.S. that is not converted to the
currency of the foreign country

15

5
Types of Long term Debt

 Treasury Notes and Bonds

Over One Year to Maturity
 Municipal Notes and Bonds
 Corporate Notes and Bonds

16

17

 Treasury Bills
 Short-Term Treasury Notes and Bonds
 Federal Agency Securities (FNME)
 Certificates of Deposit
 Eurocurrency Deposits
 Banker’s Acceptances (guarantee)
 Commercial Paper
 Short-Term Municipal Obligations
18

6
 Treasury Notes and Bonds Over One Year to
Maturity
 Municipal Notes and Bonds
 Corporate Notes and Bonds

19

 Structured Notes (from federal agency securities –

interest yields are reset periodically, packed
securities)
 Securitized Assets ( a trustee issued securities with
mortgages as collaterals, selling securities)
 Stripped Securities (separate principal and interest
payments from debt securities, selling claims)
20

 What are the main

factors affecting your
investment decision?
Why do you want to
invest and why not?

21

7
  Expected Rate of  Liquidity Risk
Return  Call Risk
 Tax Exposure  Prepayment Risk
 Interest Rate Risk  Inflation Risk
 Credit Risk  Pledging
 Business Risk Requirements

22

Yield to Maturity
n
CP t FV n
PV Bond   t

t 1 (1  YTM) (1  YTM) n
where CP are the annual coupon payments on the security and
where FV is the face value of the security
Holding Period Return
HP
CP t P
PV   
(1  HPR) (1  HPR) HP
t 1

where P is the price the security can be sold for and

where HP is the number of years the security is held
23

 Current bond price: $950, face value $1,000, interest

$100 per year in 5 years ( coupon rate 10% per year).
5
100 1,000
950  t

i 1 (1 YTM) (1 YTM)5

Put i1=12%  P1=$952.2>$950

Put i2=14%  P2=$907.2<$950
P1 P0 $952,2$950
i  i1 (i2i1) 12% (14%12%)12.1%
P1 P2 $952,2$907,2 24

8
 A 8% coupon rate bond is currently priced at
$900, face value is $1,000; was sold at year 2 with
the price of950:
2
80 950
$900   
i 1
t
(1  HPR) (1  HPR) 2

HPR = 11.51%

25

 The Tax Status of State and Local

Government Bonds
 Bank Qualified Bonds
 Tax Swapping Tool
 The Portfolio Shifting Tool

26

 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

27

9
 Investment Grade Speculative Grade

Moody’s S&P Moody’s S&P

Aaa AAA Ba BB
Aa AA B B
A A Caa CCC
Baa BBB Ca CC
C C

28

 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

29

 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

30

10
 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

31

 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
32

 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

33

11
  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

34

 The Ladder or Spaced-Maturity Policy (20-20)

 The Front-End Load Maturity Policy (30-70)
 The Back-End Load Maturity Policy (20-40-30)
 The Barbell Strategy (20-30 30-20)
 The Rate Expectation Approach (based on
interest rate expectation)
35

 The Yield Curve

 Picture of How Market Interest Rates Differ Across Differing
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

36

12
  5 year Treasury note with par value of $1,000, has current
market price of $900, pays $80 per year in interest and
YTM = 10.73%
$80 *1 $80 * 2 $80 * 3 $80 * 4 $1080 * 5
   
(1  0.1073)1 (1  1.073) 2 (1  1 .073) 3 (1  1.073) 4 (1  1.073)5
D  4.26 years
$900

 Interest rates rose from 10.73% to 12% or + 1.27%, then:

i 0 . 0127
 P   Dx ( )   4 . 26 * ( ) * 100 %   4 . 89 %
1 i 1  0 . 1073

The approximate change in T-note’s price would be – 4.89%

37

 Video: Investing for beginers!!

38

Lesson Wrap up

• Reasons for banks’ investment

• Types of financial markets
• Types of banks’ investing securities
• Factors affecting bank investment
decisions
• Investment maturity strategies
• Maturity management tools
39

13
40

14