ACTIVE

INVESTMENT
STRATEGIES
Chapter 20
Bank Management, 5th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright © 2003 by South-Western, a division of Thomson Learning
Unlike loans and deposits, which have negotiated
terms, bank investments generally represent
impersonal financial instruments.
 As such, portfolio managers can buy or sell securities
at the margin to achieve aggregate risk and return
objectives without the worry of adversely affecting
long-term depositor or borrower relationships.
 Investment strategies can subsequently play an
integral role in meeting overall asset and liability
management goals regarding interest rate risk,
liquidity risk, credit risk, the bank’s tax position,
expected net income, and capital adequacy.
 Unfortunately, not all banks view their securities
portfolio in light of these opportunities.
Many smaller banks passively manage their
portfolios using simple buy and hold strategies.
 The purported advantages are that such a policy
requires limited investment expertise and virtually
no management time, lowers transaction costs, and
provides for predictable liquidity.
 Regulators reinforce this approach by emphasizing
the risk features of investments and not available
returns.
 For example, the Comptroller’s Handbook states that
 “the investment account is primarily a
secondary reserve for liquidity rather than a
vehicle to generate speculative profits.
Speculation in marginal securities to generate
more favorable yields is an unsound banking
practice.”

The maturity or duration choice
for long-term securities
 The optimal maturity or duration is possibly
the most difficult choice facing portfolio
managers.
 It is very difficult to outperform the market
when forecasting interest rates.
 Some managers justify passive buy and hold
strategies because of a lack of time and
expertise.
 Other managers actively trade securities in an
attempt to earn above average returns.
Passive maturity strategies
 Laddered (or staggered) maturity strategy
 management initially specifies a maximum
acceptable maturity and securities are evenly
spaced throughout maturity
 securities are held until maturity to earn the
fixed returns
 Barbell maturity strategy
 differentiates investments between those
purchased for liquidity and those for income
 short term securities are held for liquidity while
long term securities for income
Comparison of laddered and barbell
maturity strategies
Percent of Portfolio
Maturing
10
1 2 3 4 5 6 7 8 9 10
Laddered Maturity Strategy
Maturity in Years
Percent of Portfolio
Maturing
40
1 2 3 4 10 11 12 13 15
Barbell Maturity Strategy
30
20
10
... ...
14
Maturity in Years
Active maturity strategies
 Active portfolio management involves taking
risks to improve total returns by adjusting
maturities, swapping securities, and
periodically liquidating discount instruments.
 To be successful, the bank must avoid the
trap of aggressively buying fixed-income
securities at relatively low rates when loan
demand is low and deposits are high.
Riding the yield curve
 This strategy works best when the yield curve
is upward-sloping and rates are stable.
 There are three basic steps:
 identify the appropriate investment horizon
 buy a par value security with a maturity longer
than the investment horizon and where the
coupon yield is higher in relationship to the
overall yield curve
 sell the security at the end of the holding
period and time remains before maturity
Buy a 5-Year Security Buy a 10-Year Security
and Sell It after 5 Years
Period:
Year-End
Coupon
Interest
Reinvestment
Income at
7%
Coupon
Interest
Reinvestment
Income at
7%
1 $7,600 - $ 8,000 -
2 7,600 $ 532 8,000 $ 560
3 7,600 1,101 8,000 1,159
4 7,600 1,710 8,000 1,800
5 7,600 2,362 8,000 2,486
Total $38,000 $5,705 $40,000 $6,005
5 Principal at Maturity = $100,000 Price at Sale after 5 years =
$101,615 when rate = 7.6%

Effect of riding the yield curve on total return when
interest rates are stable
Initial conditions
and assumptions:
•5-year
investment
horizon
•yield curve is
upward-sloping,
•5-year securities
yielding 7.6 %
and
•10-year securities
yielding 8 %.
•Annual coupon
interest is
reinvested at 7%.
Expected Total Return Calculation
( )
0.0752
1
100,000
5,705 38,000 100,000
i
1/5
5yr
=
÷
(
¸
(

¸
+ +
=
( )
0.0810
1
100,000
6,005 40,000 101,615
y
1/5
10yr
=
÷
(
¸
(

¸
+ +
=
Interest rates and the business cycle
 Expansion
 Increasing Consumer Spending, Inventory
Accumulation, and Rising Loan Demand; Federal
Reserve Begins to Slow Money Growth.
 Peak
 Monetary restraint, High Loan Demand, Little Liquidity.
 Contraction
 Falling Consumer Spending, Inventory Contraction,
Falling Loan Demand; Federal Reserve Accelerates
Money Growth.
 Trough
 Monetary Ease, Limited Loan Demand, Excess
Liquidity.

Interest rates and the business cycle
 The inverted U.S. yield curve has
predicted these recessions:


Time
I
n
t
e
r
e
s
t

R
a
t
e
s

(
P
e
r
c
e
n
t
)
Expansion
Contraction Expansion
Long-Term Rates
Short-Term Rates
Peak
Trough
Date when 1yr > 10 yr rate Time until next recession
April 1968 20 months (Dec. 1969)
March 1973 8 months (Nov 1973)
September 1978 16 months (Jan. 1980)
September 1980 10 months (July 1981)
February 1989 17 months (July 1990)
December 2000* 3 months (March 2001)
12.3 months average


Passive strategies over the business cycle.
 One popular passive investment strategy follows from the traditional
belief that a bank’s securities portfolio should consist of primary
reserves and secondary reserves.
 This view suggests that banks hold short-term, highly marketable
securities primarily to meet unanticipated loan demand and deposit
withdrawals.
 Once these primary liquidity reserves are established, banks invest
any residual funds in long-term securities that are less liquid but
offer higher yields.
 A problem arises because banks normally have excess liquidity during
contractionary periods when consumer spending is low, loan demand is
declining, unemployment is rising, and the Fed starts to pump reserves
into the banking system. Interest rates are thus relatively low.
 Banks employing this strategy add to their secondary reserve by buying
long-term securities near the low point in the interest rate cycle.
 Long-term rates are typically above short-term rates, but all rates
are relatively low.
 With a buy and hold orientation, these banks lock themselves into
securities that depreciate in value as interest rates move higher.
Active strategies and the business cycle.
 Many portfolio managers attempt to time major
movements in the level of interest rates relative to the
business cycle and adjust security maturities
accordingly.
 Some try to time interest rate peaks by following a
contracyclical investment strategy defined by
changes in loan demand.
 The strategy entails both expanding the investment
portfolio and lengthening maturities when loan
demand is high, and alternatively contracting the
portfolio and shortening maturities when loan
demand is weak.
 As such, the bank goes against the credit (lending)
cycle.
 Note that the yield curve generally inverts when
rates are at their peak prior to a recession.
Issues for securities with embedded options
 Callable agency securities or mortgage-
backed securities have embedded options.
 To value a security with an embedded option,
three questions must be addressed:
 Is the investor the buyer or seller of the
option?
 How and by what amount is the buyer being
compensated for selling the option, or how
much must it pay to buy the option?
 When will the option be exercised and what is
the likelihood of exercise?
Price-yield relationship for securities
with embedded options
Price yield relationships and duration
Yield % Price Price - $10,000 Duration
8 10,524.21 524.21 5.349
9 10,257.89 257.89 5.339
10 10,000.00 0.00 5.329
11 9,750.00 (249.78) 5.320
12 9,508.27 (491.73) 5.310
$ Price
Actual price increase is greater when
interest rates fall for option free bonds.
10,524.21

10,507.52

10,000.00



8% 10%
Interest Rate %
Price-yield curve
Tangent line representing the slope at 10%
Δi
%ΔΔ
i + 1
Δi
P
ΔP
DUR
°
÷ ~
(
(
(
¸
(

¸

÷ ~
Duration is an approximate measure of
the price elasticity of demand




 Solve for A Price:
 A P ~ - Duration x [A i / (1 + i)] x P
 Price (value) changes
 Longer maturity/duration larger changes in
price for a given change in i-rates
 Larger coupon smaller change in price for a
given change in i-rates
The relationship between duration and
actual changes in securities prices
 The difference between the actual price-yield
curve and the straight line representing
duration at the point of tangency equals the
error in applying duration to estimate the
change in bond price at each new yield.
 For both rate increases and rate decreases, the
estimated price, based on duration, will be
below the actual price.
 For small changes in yield, such as yields near 10
percent, the error is small.
 For large changes in yield, such as yields well
above or well below 10 percent, the error is large.
Duration and convexity
 The relationship between price and interest
rates is not the same for any change in
interest rates.
 Duration will generally be a ‘good’ estimate of
price volatility only for very small changes in
interest rates.
 The greater the change in interest rates, the
less accurate duration will be as a measure of
price volatility.
Convexity
 Convexity is a measure of the rate of change of dollar
duration as yields change.
 Duration, increases as yields decline and lengthens
as yields increase for all option free bonds.
 This is positive feature for buyers of bonds because as
yields decline, price appreciation accelerates.
 As yields increase, duration for option free bonds
decreases, once again reducing the rate at which price
declines.
 This characteristic is called positive convexity-- the
underlying bond becomes more price sensitive when
yields decline and less price sensitive when yields
increase.
Convexity
 The actual
reduction in
price will be less
than that
predicted by
duration with an
increase in
interest rates.
Change in price predicted by duration
yield
Price
Actual change in price
Price volatility and the impact of convexity
Yield
30 year -5% -2% 0% 2% 5%
0% 320.25% 76.13% 0.00% -42.63% -74.59%
7% 111.98% 30.74% 0.00% -20.55% -40.28%
20% 32.83% 11.03% 0.00% -9.07% -19.98%
10 year -5% -2% 0% 2% 5%
0% 61.37% 20.77% 0.00% -16.91% -36.66%
7% 44.91% 15.44% 0.00% -12.84% -28.25%
20% 25.09% 8.99% 0.00% -7.85% -17.85%
2 year -5% -2% 0% 2% 5%
0% 10.04% 3.85% 0.00% -3.64% -8.73%
7% 9.71% 3.72% 0.00% -3.52% -8.45%
20% 8.13% 3.13% 0.00% -2.98% -7.20%
Percentage Change in Price
The impact of prepayments on duration and
yield for bonds with options
 In general, market participants price mortgage-
backed securities by following a 3-step
procedure:
 estimate duration based on an assumed
interest rate environment and prepayment
speed
 identify a zero-coupon Treasury security with
the same (approximate) duration.
 the MBS is priced at a mark-up over the
Treasury.
 The MBS yield is set equal to the yield on the
same duration Treasury plus a spread.
 The spread can range from 50 to 300 basis
points depending on market conditions.
 The MBS yields reflect the zero-coupon
Treasury yield curve plus a premium.
Impacts of prepayments on modified duration
and price of a GNMA pass-through security
GNSF 7
1
/ 2 7. 5%
3/ 1/99
YI ELD TABLE
Generic: GNMA I
next pay 4/15/99 (monthly)
rcd date 3/31/99 (14 Delay)
accrual 3/ 1/99 - 3/31/99
Age
WAM*
WAC*
1
28
8
4
8.00
GNSF 7.5 A 8.000 (340) 20 WAC (UAM) CAGE
Obp 258 +300bp 94 +200bp 113 +100bp 152 -100bp 602 -200bp 817 -300bp 921
1mo
3mo
6mo
12mo
Life
B: Median :
Vary
PRICE
1
32
102-11
102-13
102-15
102-17
102-19
102-21
102-23
AvgLife
Mod Dur
6. 958
6. 943
6. 927
6. 912
6. 897
6. 882
6. 867
5. 57
4. 01
7. 214
7. 205
7. 196
7. 186
7. 177
7. 168
7. 158
11. 12
6. 54
7. 187
7. 177
7. 167
7. 157
7. 147
7. 137
7. 127
10. 10
6. 12
7. 128
7. 117
7. 105
7. 094
7. 083
7. 071
7. 060
8. 42
5. 39
6. 326
6. 296
6. 266
6. 236
6. 207
6. 177
6. 147
2. 39
2. 05
5. 866
5. 826
5. 786
5. 745
5. 705
5. 665
5. 625
1. 68
1. 51
5. 622
5. 576
5. 530
5. 484
5. 438
5. 392
5. 346
1. 45
1. 33
2. 258 PSA 94 PSA 113 PSA 152 PSA 602 PSA 817 PSA 921 PSA
592.P
587
671
524
203
30.7C
35.4
31.7
26.6
13.3
GG
<GD>
:
:
WAC - weighted
average coupon
WAM -
weighted
average
maturity
Effective duration and effective convexity
 Effective duration and effective convexity are
used to estimate a securities price sensitivity
when the security contains embedded
options.

) i (i P
P - P
duration Effective
-
0
i - i
÷
=
+
+
where
P
i-
= price if rates fall,
P
i+
= price if rates rise;
P
0
= initial (current) price;
P* = initial price
2 -
i - i
)] i [0.5(i * P
* 2P P P
convexity Effective
÷
÷ +
=
+
+
i
+
=initial market rate plus the
increase in rate;
i
-
= initial market rate minus
the decrease in rate
Effective duration and convexity for a
GNMA security
 Consider the GNMA pass-through which has 28-yrs. and 4-
months weighted average maturity
 the MBS is initially priced at 102 and 17/32nds to yield
6.912%, at 258 PSA
 At this price and PSA, MBS has and estimated average
life of 5.57 yrs. and Mod. DUR of 4.01
 Assume a 1% decline in rates will accelerate prepayments
and lead to a price of 102 while a 1% increase will slow
prepayments and produce a price of 103
 The effective duration and convexity for this security are
thus:
 Effective GNMA duration
= [102-103]/ 102.53125x(.05921 - .07921)
= -0.4877
 Effective GNMA convexity
= [102+103-2 x (102.53125)]‚102.53125[0.52(.02)2]
= -6.096
Positive and negative convexity
 Option-free securities exhibit positive
convexity because as rates increase, the
percentage price decline is less than the
percentage price increase associated with the
same rate decline.
 Securities with embedded options may exhibit
negative convexity -- the percentage price
increase is less than the percentage price
decrease for equal negative and positive
changes in rates.
Total return analysis
…An investor’s actual realized return should
reflect the coupon interest, reinvestment income,
and value of the security at maturity or sale at the
end of the holding period.
 When a security carries embedded options, such as
the prepayment option with mortgage-backed
securities, these component cash flows will vary in
different interest rate environments.
 For example, if rates fall and borrowers prepay faster
than originally expected, coupon interest will fall as the
outstanding principal falls, reinvestment income will
fall because rates are lower when the proceeds are
reinvested and less coupon interest is received, and
the price at sale (end of the holding period) may rise or
fall depending on the speed of prepayments.
 When rates rise, borrowers prepay slower so that
coupon income increases, reinvestment income
increases, and the price at sale (end of the holding
period) again may rise or fall.
Total return analysis for a callable FHLB Bond
Total return analysis for a callable FHLB Bond
Option-adjusted spread
 Standard calculation of yield to maturity is
inappropriate with prepayment risk.
 Option-adjusted spread (OAS) accounts for factors
that potentially affect the likelihood and frequency of
call and prepayments.
 Static spread is the yield premium, in percent, that
(when added to Treasury zero coupon spot rates along
the yield curve) equates the present value of the
estimated cash flows for the security with options
equal to the prevailing price of the matched-maturity
Treasury.
 OAS represents the incremental yield earned by
investors from a security with options over the
Treasury spot curve, after accounting for when and at
what price the embedded options will be exercised.
OAS analysis is one procedure to estimate
how much an investor is being
compensated for selling an option to the
issuer of a security with options.
 The approach starts with estimating Treasury
spot rates (zero coupon Treasury rates) using a
probability distribution and Monte Carlo
simulation, identifying a large number of possible
interest rate scenarios over the time period that
the security’s cash flows will appear.
 The analysis then assigns probabilities to various
cash flows based on the different interest rate
scenarios.
 For mortgages, one needs a prepayment model
and for callable bonds, one needs rules and prices
indicating when the bonds will be called and at
what values.
OAS analysis involves three basic
calculations
1. For each scenario, a yield premium is added to the
Treasury spot rate (matched maturity zero coupon
Treasury rate) and used to discount the cash flows.
2. For every interest rate scenario, the average present
value of the security’s cash flows is calculated.
3. The yield premium that equates the average present
value of the cash flows from the security with
options to the prevailing price of the security
without options is the OAS.
 Conceptually, OAS represents the incremental yield
earned by investors from a security with options
over the Treasury spot curve, after accounting for
when and at what price the embedded options will
be exercised.

S
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C u r r e n t T r e a s u r y C u r v e
( M e a n )
D i s t r i b u t i o n o f
I n t e r e s t R a t e s
R a t e V o l a t i l i t y E s t i m a t e s
( V a r i a n c e )
P r e p a y m e n t M o d e l
F i n d S p r e a d O v e r
T r e a s u r y R a t e s S u c h T h a t
M a r k e t P r i c e = P r e s e n t
V a l u e o f C a s h F l o w s
O p t i o n - A d j u s t e d
S p r e a d
C a l c u l a t e D u r a t i o n
a n d C o n v e x i t y
S h o c k R a t e s U p
a n d D o w n
M a r k e t P r i c e o f
M o r t g a g e S e c u r i t y
S e c u r i t y - S p e c i f i c
I n f o r m a t i o n : C o u p o n
R a t e , M a t u r i t y , e t c .
O t h e r P r e p a y m e n t
F a c t o r s
P o s s i b l e C a s h F l o w s
f o r m M o r t g a g e S e c u r i t y
Option-adjusted spread analysis for a callable
FHLB bond
Comparative yields on taxable versus tax-
exempt securities
 A bank’s effective return from investing in
securities depends:
 on the amount of interest income,
 reinvestment income,
 potential capital gains or losses,
 whether the income is tax-exempt or taxable,
and
 whether the issuer defaults on interest and
principal payments.
 When making investment decisions, portfolio
managers compare expected risk-adjusted
after-tax returns from alternative investments.
 they purchases securities that provide the
highest expected risk-adjusted return
Why are municipal securities so
attractive to banks?
 Most municipal securities are federal income tax
exempt.
 Suppose that you could borrow funds at 6%,
deduct your interest expense at a 34% tax rate,
and buy securities that pay tax-exempt interest at
5.75%.
 Your before tax spread would be negative 0.25%
but your after tax spread would be 1.79%
 after tax spread = 5.75% - [6% x (1 - 0.34)]
= 1.79%
 Ignoring credit and interest rate risk issues, you
would effectively pay 3.96% on borrowings:
= 6% x (1 – 0.34)
After-tax and tax-equivalent yields
 Once the investor has determined the
appropriate maturity and risk security, the
investment decision involves selecting the
security with the highest after-tax yield.
 Tax-exempt and taxable securities can be
compared as:
t) (1 R R
t m
÷
s
>
where
R
m
= pretax yield on a municipal security
R
t
= pretax yield on a taxable security
t = investor’s marginal federal income tax rate
Example: After tax returns
 Let:
R
m
= 5.75%
R
t
= 7.50%
bank's average cost of funds = 6.00%
marginal tax rate = 34%

 The investor would choose the municipal
because it pays a higher after tax return:

R
m
= 5.75% after taxes

R
t
= 7.50% (1 - 0.34)
= 4.95% after taxes
Marginal tax rates implied in the
taxable - tax-exempt spread.
 If taxable securities (Corp.) and tax-exempt
securities (Muni's) are the same for all other
reasons then:
 t* = 1 - (R
m
/ R
t
)
 where
R
m
= pretax yield on a municipal security
 R
t
= pretax yield on a taxable security
 t* represents the marginal tax rate at which an
investor would be indifferent between a taxable
and a tax-exempt security equal for all other
reasons.
 Higher marginal tax rates or high tax individuals
(companies) will prefer tax-exempt securities.
Example: Implied marginal tax rate
 Let:
R
m
= 5.75%
R
t
= 7.50%
bank's average cost of funds = 6.00%
marginal tax rate = 34%



 An Investor would be indifferent between
these two investment alternatives if her
marginal tax rate were 23.33%
23.33%
7.50%
5.75%
1 t
*
= ÷ =
Municipals and state and local taxes
 The analysis is complicated somewhat when
state and local taxes apply to municipal
securities:

 Many analysts compare securities on a pre-
tax basis
 To compare municipals on a tax equivalent
basis (pre-tax):
)] t (t [1 R ) t (t R
m t m m
+ ÷ ÷
s
>
t) (t 1
) t (t R
yield equivalent tax
m
m m
+ ÷
÷
= ÷
Deductibility of interest expense
 Prior to 1983, banks could deduct the full
amount of interest paid on liabilities used to
finance the purchase of muni's.
 After 1983; however, 15% was not deductible
and after 1984 20% was not deductible.
 The 1986 tax reform act made 100% not
deductible except for qualified muni's, small
issue (less than 10 million).
 The loss of interest expense deductibility will,
in effect, be like an implicit tax on the bank's
holding of municipal securities.
Example: using previous data.
 Before tax spread:
R
t
= 7.5% - 6.0% = 1.50%
R
m
= 5.75% - 6.0% = -0.25%
 After tax spread if 100% of interest expense used to
finance Muni's is deductible; i.e., banks before 1983:
R
t
= 7.5% (1 - 0.34) - 6.0% (1 - 0.34) = 0.99%
R
m
= 5.75% - 6.0% (1 - 0.34) = 1.79%
 After tax spread if 20% of interest expense used to
finance Muni's is not deductible:
R
t
= 7.5% (1 - 0.34) - 6.0% (1 - 0.34) = 0.99%
R
m
= 5.75% - 6.0% (1 - 0.34 x 0.8) = 1.38%
 After tax spread if 100% of interest expense used to
finance Muni's is not deductible; after 1986 III:
R
t
= 7.5% (1 - 0.34) - 6.0% (1 - 0.34) = 0.99%
R
m
= 5.75% - 6.0% (1 - 0.34 x 0.0) =-0.25%
Interest deductibility
 Lost deductibility of interest expense is
somewhat equivalent to an implied tax on
municipal income.
 To calculate after tax yields on muni's, if
interest expense is not fully deductible,
calculate the banks effective tax rate on
municipals:
local and state
R
cost
interest
Pooled
Deductable
%not
t
t
muni
m
+
(
(
(
¸
(

¸

×
(
¸
(

¸

×
=
Example: Implied tax on bank’s
purchase of municipal securities
 Assume
 t =34%,
 20% not deductible,
 7.5% pooled interest cost,
 R
muni
= 7%.



7.49% 0.0638) (1 8.0 R
at
muni
= ÷ × =
6.38% 0
0.08
(0.075) (0.20) (0.34)
t
muni
= +
× ×
=
Comparison of after-tax returns on taxable and
tax-exempt securities for a bank as investor
C. After-Tax Interest Earned Recognizing Partial
Deductibility of Interest Expense
A. After-Tax Interest Earned on Taxable versus Exempt Securities
Taxable Municipal
Par Value 10,000 $ 10,000 $
Coupon Rate 10.00% 8.00%
Annual Coupon interest 1,000 $ 800 $
Federal income taxes (34%) 340 $ $0
After-tax income 660 $ 800 $
Par Value 10,000 $ 10,000 $
Coupon Value 0 $ 0 $
Annual coupon interest 1,000 $ 800 $
Federal income taxes (34%) 340 $ - $
Polled interest expense (7.5%) 750 $ 750 $
Lost interest deduction (20%) - $ 150 $
Increased tax liability (34%) - $ 51 $
Effective after-tax interest income 660 $ 749 $
After-tax interest earned, recognizing partial
deductibility of interest expense: Individual asset
Factors affecting allowable deduction:
Total interest expense paid 1,500,000 $
Average amount of assets owned 20,000,000 $
Average amount of tax exempt securities owned: 800,000 $
Weighted average cost of financing 7.50%
Nondeductible interest expense:
Pro rata share of interest expense to carry muni's 4.00%
Nondeductible interest expense (20%) 12,000 $
Deductible interest expense: $1,500,000 - $12,000 = 1,488,000 $
The impact of the tax reform
act of 1986 (TRA 1986)
 The TRA of 1986 created two classes of
municipals:
1. Qualified and
2. Nonqualified Municipals
 After 1986, banks can no longer deduct
interest expenses associated with municipal
investments, except for qualified municipal
issues.
Qualified versus nonqualified municipals
 Qualified Municipals
 banks can still deduct 80 percent of the
interest expense associated with the purchase
of certain small issue public-purpose bonds.
 Nonqualified Municipals
 all municipals that do not meet the qualified
criteria.
 Municipals issued before August 7, 1986,
retain their tax exemption; i.e., can still deduct
80 percent of their associated financing costs
(grandfathered in).
Example: Implied tax on bank’s
purchase of nonqualified municipal
securities (100% lost deduction)
 Assume
 t =34%,
 20% not deductible,
 7.5% pooled interest cost,
 Rmuni = 7%.



% 45 . 5 ) 3188 . 0 1 ( 0 . 8 R
at
muni
= ÷ × =
% 88 . 31 0
08 . 0
) 075 . 0 ( ) 00 . 1 ( ) 34 . 0 (
t
muni
= +
× ×
=
Strategies underlying security swaps
 Active portfolio strategies also enable banks
to sell securities prior to maturity whenever
economic conditions dictate that returns can
be earned without a significant increase in
risk.
 When a bank sells a security at a loss prior to
maturity, because interest rates have
increased, the loss is a deductible expense.
 At least a portion of the capital loss is
reduced by the tax-deductibility of the loss.
Evaluation of security swaps
Par Value
Market
Value
Remain
Maturity
Semiann
Coupon YTM
A. Classic Swap Description
Sell US Trea bonds @ 10.50% $2,000,000 $1,926,240 3 $105,000 12.00%
Buy FHLMC bons @ 12.20% $1,952,056 $1,952,056 3 $119,075 12.20%
B. Swap with Minimal Tax Effects
Sell US Treas bons @ 10.50% $2,000,000 $1,926,240 3 $105,000 12.00%
Sell FNMA @ 13.80% $3,000,000 $3,073,065 4 $207,000 13.00%
Total $5,000,000 $4,999,305 $312,000
Buy FNMA @ 13.00% $5,000,000 $5,000,000 1 $325,000 12.00%
13,000 $
C. Present Value Analysis
Period 0 1 2 3 4 5 6
Treas Cash flow $1,926,240 ($105,000) ($105,000) ($105,000) ($105,000) ($105,000) ($2,105,000)
Tax savings $25,816
FHLMC ($1,952,056) $119,075 $119,075 $119,075 $119,075 $119,075 $2,071,132
Difference: $0 $14,075 $14,075 $14,075 $14,075 $14,075 ($33,868)
$35,380
1.061
14,075 47,944
1.061
14,075
PV
6
6
1 t
t
=
+ ÷
+ =
¿
=
Security swap example
 Tax Savings:
 = (2,000,000 - 1,926,240) * 0.35 = 25,816

 After Tax Proceeds
 = 1,926,240 + 25,816 = 1,952,056

 Present Value of the Difference:
$35,380
1.061
14,075 47,944
1.061
14,075
PV
6
6
1 t
t
=
+ ÷
+ =
¿
=
In general, banks can effectively
improve their portfolios by
 Upgrading bond credit quality by shifting into
high-grade instruments when quality yield
spreads are low
 Lengthening maturities when yields are
expected to level off or decline
 Obtaining greater call protection when
management expects rates to fall
 Improving diversification when management
expects economic conditions to deteriorate
 Generally increasing current yields by taking
advantage of the tax savings
 Shifting into taxable securities from
municipals when management expects losses
Leveraged arbitrage strategy
 During the mid- to late-1990s, many bank managers
believed that their banks were under-leveraged.
 Too little debt relative to stockholders’ equity lowered
the equity multiplier and reduced ROE, given the strong
ROAs that were being generated.
 To increase earnings and make the bank more
expensive if an acquirer was interested in buying the
bank, some portfolio managers implemented a
leveraged arbitrage strategy involving borrowing from
the Federal Home Loan Bank and using the proceeds
to buy securities.
 The specific strategy consists of matching the
maturity of FHLB advances with the call dates of
callable agency bonds and the maturity dates of
securities currently held in the investment portfolio.
Example: Leveraged arbitrage strategy
 Consider a bank with $100 million in assets and $12 million in
stockholders’ equity that expects to earn $1.5 million, or 1.5 percent on
assets.
 The bank would report an equity multiplier of 8.33 and an ROE of 12.5%.
 The bank owns $3 million of Treasury securities @ 5.4% that mature in
one year, and $3 million in Farm Credit Bank bonds@ 5.7% that mature
in 18 months.
 It can borrow from the FHLB for one year at 6 percent and for 18 months
at 6.2%.
 The leveraged arbitrage strategy involves borrowing from the FHLB at
these maturities and buying callable agency bonds with call dates at
one year and 18 months, respectively.
 For example, assume that a 5-year maturity bond, noncallable for one
year, yields 7 percent, while a 7-year bond that is noncallable for 18
months yields 7.25 percent.
 The spread between the respective advances and callable agencies is
Agency Interest FHLB Advance Interest Spread
5 NC 1 year 7% 6% 1%
7 NC 18 mo. 7.25% 6.2% 1.05%
 If the transactions amounts were the same $3 million, the bank would
earn an additional $61,500 in net interest income over the year.
 This would lower the bank’s ROA to 1.45 percent, but increase the
bank’s ROE to 12.84 percent.
ACTIVE
INVESTMENT
STRATEGIES
Chapter 20
Bank Management, 5th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright © 2003 by South-Western, a division of Thomson Learning

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