Solution manual bank management and financial services 9th edition by rose, peter chap010

Chapter 10 - The Investment Function in Financial-Services Management CHAPTER 10 THE INVESTMENT FUNCTION IN FINANCIAL-SERVICES MANAGEMENT Goal of This Chapter: The purpose of this chapter is to discover the types of securities that financial institutions acquire for their investment portfolio and to explore the factors that a manager should consider in determining what securities a financial institution should buy or sell Key Topics in This Chapter        Nature and Functions of Investments Investment Securities Available: Advantages and Disadvantages Measuring Expected Returns Taxes, Credit, and Interest-Rate Risks Liquidity, Prepayment, and Other Risks Investment Maturity Strategies Maturity Management Tools Chapter Outline I II III IV V VI VII Introduction Investment Instruments Available to Financial Firms Popular Money Market Investment Instruments A Treasury Bills B Short-Term Treasury Notes and Bonds C Federal Agency Securities D Certificates of Deposit E International Eurocurrency Deposits F Bankers' Acceptances G Commercial Paper H Short-Term Municipal Obligations Popular Capital Market Investment Instruments A Treasury Notes and Bonds B Municipal Notes and Bonds C Corporate Notes and Bonds Investment Instruments Developed More Recently A Structured Notes B Securitized Assets C Stripped Securities Investment Securities Held by Banks Factors Affecting Choice of Investment Securities A Expected Rate of Return B Tax Exposure The Tax Status of State and Local Government Bonds The Impact of Changes in Tax Laws 10-1 Chapter 10 - The Investment Function in Financial-Services Management VIII IX X Bank Qualified Bonds The Tax Swapping Tool The Portfolio Shifting Tool C Interest Rate Risk D Credit or Default Risk E Business Risk F Liquidity Risk G Call Risk H Prepayment Risk I Inflation Risk J Pledging Requirements Investment Maturity Strategies A The Ladder, or Spaced-Maturity, Policy B The Front-End Load Maturity Policy C The Back-End Load Maturity Policy D The Barbell Strategy E The Rate Expectations Approach Maturity Management Tools A The Yield Curve Forecasting Interest Rates and the Economy Risk-Return Trade-Offs Pursuing the Carry Trade Riding the Yield Curve B Duration Immunization Summary of the Chapter Concept Checks 10-1 Why banks and other institutions choose to devote a significant portion of their assets to investment securities? The primary function of most banks and other depository institutions is not to buy and sell bonds, but rather to make loans to businesses and individuals After all, loans support business investment and consumer spending in local communities and provide jobs and income to thousands of community residents However, many loans are illiquid—they cannot easily be sold or securitized prior to maturity And loans are among the riskiest assets, generally carrying the highest customer default rates of any form of credit Also, loan income is usually taxable for banks and selected other financial institutions, necessitating the search for tax shelters in years when earnings from loans are high For all these reasons depository institutions, have devoted a significant portion of their asset portfolios—usually somewhere between a fifth to a third of all assets—to another major category of earning asset: investments in securities that are under the management of investments officers These instruments typically include government bonds and notes; corporate bonds, notes, and 10-2 Chapter 10 - The Investment Function in Financial-Services Management commercial paper; asset-backed securities arising from lending activity; domestic and Eurocurrency deposits; and certain kinds of common and preferred stock permitted by law 10-2 What key roles investments play in the management of a depository institution? Investment security portfolios perform many different roles that act as a necessary complement to the advantages loans provide They help stabilize income when loan revenues fall Investment in high-quality securities can be purchased and held to balance out the risk from loans Investment in securities allow the bank or thrift institution to diversify into different localities than most of its loans permit, provide additional liquid reserves in case more cash is needed, provide collateral as called for by law and regulation to back government deposits Security investments aid banks in reducing their exposure to taxes, and also help hedge against losses due to changing interest rates Investment securities, unlike many loans, can be bought or sold quickly to restructure assets, hence providing flexibility to the banks Over and above, the bank managers can also dress up the balance sheet and make a financial institution look financially stronger due to the high quality of many marketable securities 10-3 What are the principal money market and capital market instruments available to institutions today? What are their most important characteristics? Banks purchase a wide range of investment securities The principal money market instruments available to banks today are Treasury bills, short-term Treasury notes and bonds, federal agency securities, certificates of deposits issued by other depository institutions, international Eurocurrency deposits, bankers' acceptances, commercial paper, and short-term municipal obligations The common characteristics of most these instruments are their safety and high marketability Capital market instruments available to banks include U.S Treasury notes and bonds, municipal notes and bonds, and corporate notes and bonds The characteristics of these securities are their higher expected rate of return and capital gains potential 10-4 What types of investment securities banks seem to prefer the most? Can you explain why? Commercial banks clearly prefer these major types of investment securities: U S government obligations, federal agency securities, and state and local government obligations, and assetbacked securities They also hold small amounts of equities and other domestic and foreign debt securities (mainly corporate notes and bonds) They pick these types because they are best suited to meet the objectives of a bank’s investment portfolio, such as a comparatively high yield, tax sheltering, reducing overall risk exposure, a source of liquidity, and generating income as well as diversifying their assets 10-5 What are securitized assets? Why have they grown so rapidly in recent years? Securitized assets are loans that are placed in a pool and, as the loans generate interest and principal income, that income is passed on to the holders of securities representing an interest in the loan pool These loan-backed securities are attractive to many banks because of their higher 10-3 Chapter 10 - The Investment Function in Financial-Services Management yields Also, guarantees are received from government agencies (in the case of most homemortgage-backed securities) or from private institutions such as banks or insurance companies pledging to back credit card loans The loan-backed securities are also attractive because of their relatively high liquidity and marketability of securities backed by loans compared to the liquidity and marketability of loans themselves 10-6 What special risks securitized assets present to institutions investing in them? Securitized assets often carry substantial prepayment risk, which arises when certain loans in the securitized-asset pool are paid off early by the borrowers (usually because interest rates have fallen and new loans can be substituted for the old loans at cheaper loan rates) Prepayment risk can significantly decrease the values of securities backed by loans and change their effective maturities, thus making the holder of the security receive diminished income Also, a substantial weakness among these securitized assets is that, there can be a sharp deterioration in the underlying assets’ (loans) market values when they experience a significant rise in default rates 10-7 What are structured notes and stripped securities? What unusual features they contain? Structured notes usually are packaged investments, such as pools of federal agency securities, assembled by security dealers that offer customers flexible yields in order to protect their customers' investments against losses due to changing interest rates Interest yield on such notes could be reset periodically based on a reference interest rate, such as a U.S Treasury bond rate Stripped securities represent a claim against either the principal or interest payments associated with a debt security The expected cash flow from a Treasury note, Treasury bond or mortgagebacked security is separated into a stream of principal payments and a stream of interest payments, each of which may be sold as a separate security maturing on the day the payment is due In particular, stripped securities offer interest-rate hedging possibilities to help protect an investment portfolio against loss from interest-rate changes 10-8 How is the expected yield on most bonds determined? For most bonds, determining the expected yield requires the calculation of the yield to maturity (YTM), if the bond is to be held to maturity or the planned holding period yield (HPY) between point of purchase and point of sale YTM determines the yield on a bond that equalizes the market price of the bond with its expected stream of cash flows However, many financial firms frequently not hold all their investments to maturity Some must be sold off early to accommodate new loan demand or to cover deposit withdrawals To deal with this situation, the investments officer needs to calculate the holding period yield (HPY) The HPY is simply the rate of return (discount factor) that equates a security’s purchase price with the stream of income expected until it is sold to another investor 10-4 Chapter 10 - The Investment Function in Financial-Services Management 10-9 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 $1,000 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 yield be? The relevant formula for YTM is: $100 $100 $1,000 $950 = + + (1 + YTM) (1 + YTM) (1 + YTM) Using a financial calculator we determine the YTM to be 13 percent If the bond is sold after one year, the formula to find investor’s holding period yield is: $100 $970 $950 = + (1 + HPY) (1 + HPY)1 Therefore, the HPY when the bond is sold after one year is 12.63 percent 10-10 What forms of risk affect investments? The following forms of risk affect investments: a interest rate risk, b credit or default risk, c business risk, d liquidity risk, e prepayment risk, f call risk, and g inflation risk Interest-rate risk captures the sensitivity of the value of investments to interest-rate movements while credit risk reflects the risk that the security issuer may default on either interest or principal payments Business risk refers to the impact of credit conditions and the economy, where delinquent loans may rise as borrowers struggle to generate enough cash flow to pay the lender Liquidity risk focuses on the price stability and marketability of investments Prepayment risk is specific to certain types of investments and focuses on the fact that some loans, which the securities are based on, can be paid off early Call risk refers to the early retirement of some government and corporate securities and inflation risk refers to the possible loss of purchasing power of interest income and repaid principal from a security or a loan 10-11 years? How has the tax exposure of various U.S bank security investments changed in recent In recent years, the government has treated interest income and capital gains from most bank investments as ordinary income for tax purposes In the past, only interest was treated as ordinary income and capital gains were taxed at a lower rate Tax reform in the United States has 10-5 Chapter 10 - The Investment Function in Financial-Services Management also had a major impact on the relative attractiveness of state and local government bonds due to declining tax advantages, lower corporate tax rates and fewer qualified tax-exempt securities 10-6 Chapter 10 - The Investment Function in Financial-Services Management 10-12 Suppose a corporate bond an investments officer would like to purchase for her bank has a before-tax yield of 8.98 percent and the bank is in the 35 percent federal income tax bracket What is the bond's after-tax gross yield? What after-tax rate of return must a prospective loan generate to be competitive with the corporate bond? Does a loan have some advantages for a lending institution that a corporate bond would not have? After-tax gross yield on corporate bond = 8.98 percent × (1 − 0.35) = 5.84 percent A prospective loan must generate a comparable yield to that of the bond to be competitive However, granting a loan to a corporation may have the added advantage of bringing in additional service business for the bank that merely purchasing a corporate bond would not Also, the management may desire to keep good loan customers, or there can be changes in the state and local government credit quality In such cases, the bank would probably be willing to accept a lower yield on the loan compared to the bond in anticipation of getting more total revenue from the loan relationship due to the sale of other bank services 10-13 What is the net after-tax return on a qualified municipal security whose nominal gross return is percent, the cost of borrowed funds is percent, and the financial firm holding the bond is in the 35 percent tax bracket? What is the tax-equivalent yield (TEY) on this tax-exempt security? Net after-tax return on municipals (in percent) =  Nominal return on municipals after taxes (in percent)   Interest expense incurred in acquiring the municipals (in percent)    + Tax advantage of a qualified bond Tax advantage of qualified bond =  The bank's marginalincome tax rate (in percent) ×   Percentage of interest expense that is still tax deductible ×     Interest expense of acquiring the municipals (in percent)  Net after-tax return = (0.06 − 0.05) + (0.35 × 0.80 × 0.05) = 0.024 or 2.4 percent Tax-equivalent yield = After-tax return on a tax-exempt investment  - Investing firm's marginal tax rate  The security's tax-equivalent yield in gross terms: percent = = 0.0923 or 9.23 percent  - 0.35 10-14 Spiro Savings Bank currently holds a government bond valued on the day of its purchase at $5 million, with a promised interest yield of percent, whose current market value is 10-7 Chapter 10 - The Investment Function in Financial-Services Management $3.9 million Comparable quality bonds are available today for a promised yield of percent What are the advantages to Spiro Savings from selling the government bond bearing a percent promised yield and buying some percent bonds? In this instance the bank could sell the 6-percent bonds, buy the 8-percent bonds, and experience an extra percent in yield The bank would experience a capital loss of $1.1 million from the bond's book value, but the after-tax loss would be only $1.1 million × (1 − 0.35) or $715,000 10-15 What is tax swapping? What is portfolio shifting? Give an example of each A tax swap involves exchanging one type of investment security for another when it is advantageous to so in reducing the bank's current or future tax exposure For example, the bank may sell lower-yielding securities at a loss in order to reduce its current taxable income, while simultaneously purchasing new higher-yielding securities in order to boost future returns on its investment portfolio or to replace taxable securities with tax-exempt securities Portfolio shifting which involves selling certain securities out of a bank's portfolio, often at a loss, and replacing them with other securities, is usually carried out to gain additional current income, add to future income, or to minimize a bank's current or future tax liability For example, the bank may shift its holdings of investment securities by selling off selected lower-yielding securities at a loss, and substituting higher-yielding securities in order to offset large amounts of loan income, thereby reducing their tax liability 10-16 Why depository institutions face pledging requirements when they accept government deposits? Pledging requirements are in place to safeguard the deposit of public funds At least the first $100,000 of public deposits is covered by federal deposit insurance; the rest must be backed up by bank holdings of U.S Treasury and federal agency securities valued at their par values 10-17 What types of securities are used to meet collateralization requirements? When a bank borrows from the discount window of its district Federal Reserve Bank, it must pledge either federal government securities or other collateral acceptable to the Fed Typically, banks will use U.S Treasury and federal securities to meet these collateral requirements Some municipal bonds (provided they are at least A-rated) can also be used to secure the federal government’s deposits in depository institutions If the bank raises funds through repurchase agreements (RPs), banks must pledge securities, typically U.S Treasury and federal agency issues, as collateral in order to borrow at the low RP interest rate 10-18 What factors affect a financial-service institution’s decision regarding the different maturities of securities it should hold? 10-8 Chapter 10 - The Investment Function in Financial-Services Management In choosing among various maturities of short-term and long-term securities to hold, the financial institution needs to carefully consider the use of two key maturity management tools— the yield curve and duration These two tools help management understand more fully the consequences and potential impact on earnings and risk of any particular maturity mix of securities they choose 10-19 What maturity strategies financial firms employ in managing their portfolios? In choosing the maturity distribution of securities to be held in the financial firm’s investment portfolio one of the following strategies typically is chosen by most institutions: a The Ladder, or Spaced-Maturity, Policy b The Front-End Load Maturity Policy c The Back-End Load Maturity Policy d The Barbell Strategy e The Rate Expectations Approach The ladder or spaced-maturity strategy involves equally spacing out a bank's security holdings over its preferred maturity range to stabilize investment earnings The front-end load maturity strategy implies that a bank will pile up its security holdings into the shortest maturities to have maximum liquidity and minimize the risk of loss due to rising interest rates The back-end loaded maturity policy calls for placing all security holdings at the long-term end of the maturity spectrum to maximize potential gains if interest rates fall and to earn the highest average yields The barbell strategy places a portion of the bank's security holdings at the short-end of the maturity spectrum and the rest at the longest maturities, thus providing both liquidity and maximum income potential Finally, the rate expectations approach, the most aggressive of all maturity strategies, calls for shifting maturities toward the short end if rates are expected to rise and toward the long-end of the maturity scale if interest rates are expected to fall 10-20 Bacone National Bank has structured its investment portfolio, which extends out to four-year maturities, so that it holds about $11 million each in one-year, two-year, three-year, and four-year securities In contrast, Dunham National Bank and Trust holds $36 million in one- and two-year securities and about $30 million in 8- to 10-year maturities What maturity strategy is each bank following? Why you believe that each of these banks has adopted the particular strategy it has as reflected in the maturity structure of its portfolio? Bacone National Bank has structured its investment portfolio to include $11 million equally in each of four one-year maturity intervals This is clearly a spaced-maturity or ladder policy In contrast, Dunham National Bank holds $36 million in one and two-year securities and about $30 million in 8- and 10-year maturities, which is clearly a barbell strategy Dunham National Bank pursues its strategy to provide both liquidity (from the short maturities) and high income (from the long maturities), while Bacone National is a small bank that needs less income fluctuations and a simple-to-execute strategy 10-9 Chapter 10 - The Investment Function in Financial-Services Management 10-21 How can the yield curve and duration help an investments officer choose which securities to acquire or sell? Yield curves possibly provide a forecast of the future course of short-term rates, telling us what the current average expectation is in the market The yield curve also provides an indication of equilibrium yields at varying maturities and, therefore, gives an indication if there are any significantly underpriced or overpriced securities Finally, the yield curve's shape gives the bank's investment officer a measure of the yield trade-off—how much yield can be earned replacing shorter-term securities with longer-term issues, or vice versa Duration tells a bank about the price volatility of its earning assets and liabilities due to changes in interest rates Higher values of duration imply greater risk to the value of assets and liabilities held by a bank For example, a loan or security with a duration of years stands to lose twice as much in terms of value for the same change in interest rates as a loan or security with a duration of years 10-22 A bond currently sells for $950 based on a par value of $1,000 and promises $100 in interest for three years before being retired Yields to maturity on comparable-quality securities are currently at 12 percent What is the bond’s duration? Suppose interest rates in the market fall to 10 percent What will be the approximate percent change in the bond’s price? Period of Expected Cash Flow Expected Cash Flow from loan $ 100 100 1,100 Present Value of Annual Interest (at 12 percent YTM in this case) $ 89.29 79.72 782.96 Time Period Cash Is to Be Received (t) Present Value of Expected Cash Flows × t $ 89.29 159.44 2,348.87 PV of Cash Flows × t = $2,597.60 Hence, duration of the bond = $2,597.60 ÷ $950= 2.73 years If interest in the market fall to 10 percent, the approximate percentage change in the bond's price will be: Δi Percentage change in price  -D × (1 + i) -0.02 = -2.73 × = -0.0488 or -4.88 percent (1 + 0.12) Therefore, the bond’s price will approximately reduce by 4.88 percent 10-10 Chapter 10 - The Investment Function in Financial-Services Management Problems and Projects 10-1 A 20-year U.S Treasury bond with a par value of $1,000 is currently selling for $1,025 from various securities dealers The bond carries a percent coupon rate with payments made annually If purchased today and held to maturity, what is its expected yield to maturity? (Hint - the following relationships can help in solving for the yield: If price < par value, then yield > coupon rate; If price = par value, then yield = coupon rate; If price > par value, then yield < coupon rate.) Since the bond is selling at a premium, that is, price > par value, the yield will be less than the coupon rate, or a yield < percent The relevant formula for YTM is: $60 $60 $60 $1000 $1,015 = + + + + 20 (1 + YTM) (1 + YTM) (1 + YTM) (1 + YTM) 20 YTM = 5.79 percent (using a financial calculator.) 10-2 A municipal bond has a $1,000 face (par) value Its yield to maturity is percent, and the bond promises its holders $60 per year in interest (paid annually) for the next 10 years before it matures What is the bond’s duration? Annual Interest Income $ 60 60 60 60 60 60 60 60 60 60 1,000 Year 10 10 PV of Annual Interest $ 57.14 54.42 51.83 49.36 47.01 44.77 42.64 40.61 38.68 36.83 613.91 $1,077.22 PV of PV At 5% 0.95238 0.90703 0.86384 0.82270 0.78353 0.74622 0.71068 0.67684 0.64461 0.61391 0.61391 Annual Year × × × × × × × × × × × Time Period Recorded 10 10 PV Annual Period Income @ 5% Interest Record ed 60 60 0.9523 0.9070 = = = = = = = = = = = Time Interest Time Weighted PV $ 57.14 108.84 155.49 197.45 235.06 268.64 298.49 324.88 348.09 368.35 6,139.13 $8,501.56 Time Weighte d PV 57.14 x = 57.14 54.42 x = 108.84 10-11 Chapter 10 - The Investment Function in Financial-Services Management 60 60 60 60 60 60 60 10 60 10 1,000 0.8638 0.8227 0.7835 0.7462 0.7106 0.6768 0.6446 0.6139 0.6139 51.83 x = 155.49 49.36 x = 197.45 47.01 x = 235.06 44.77 x = 268.64 42.64 x = 298.49 40.61 x = 324.88 38.68 x = 348.09 36.83 x 10 = 368.35 613.91 x 10 = 6139.13 1077.22 8501.56 Then, duration of the bond = $ 8,501.56 ÷ $1,077.22 = 7.89 years 10-3 Calculate the yield to maturity of a 20-year U.S government bond that is selling for $975 in today’s market and carries a percent coupon rate with interest paid semiannually The relevant formula for YTM is: $975 = $25 $25 $25 $1000 + + + + 40 (1 + YTM/2) (1 +YTM/2) (1 + YTM/2) (1 + YTM/2) 40 YTM/2 = 2.60 percent, YTM = 5.20 percent (using a financial calculator) 10-4 A corporate bond being seriously considered for purchase by Old Dominion Financial will mature 20 years from today and promises a percent interest payment once a year Recent inflation in the economy has driven the yield to maturity on this bond to 10 percent, and it carries a face value of $1,000 Calculate this bond’s duration Annual PV of Interest PV Annual Year Income at 10% Interest $70 0.909 $ 63.64 70 0.826 57.85 70 0.751 52.59 70 0.683 47.81 70 0.621 43.46 × × × × × Time Period Recorded 10-12 = = = = = Time Weighted PV $ 63.64 115.70 157.78 191.24 217.32 Chapter 10 - The Investment Function in Financial-Services Management 10 11 12 13 14 15 16 17 18 19 20 20 70 70 70 70 70 70 70 70 70 70 70 70 70 70 70 1000 0.564 0.513 0.467 0.424 0.386 0.350 0.319 0.290 0.263 0.239 0.218 0.198 0.180 0.164 0.149 0.149 39.51 35.92 32.66 29.69 26.99 24.53 22.30 20.28 18.43 16.76 15.23 13.85 12.59 11.45 10.41 148.64 $744.59 × × × × × × × × × × × × × × × × 10 11 12 13 14 15 16 17 18 19 20 20 = = = = = = = = = = = = = = = = 237.08 251.45 261.24 267.18 269.88 269.88 267.65 263.59 258.06 251.36 243.74 235.44 226.62 217.47 208.10 2972.87 $7,447.31 Therefore, the bond's duration is: $7,447 ÷ $744.59 = 10.002 years 10-5 Forever Savings Bank regularly purchases municipal bonds issued by small rural school districts in its region of the state At the moment, the bank is considering purchasing an $8 million general obligation issue from the York school district, the only bond issue that district plans this year The bonds, which mature in 15 years, carry a nominal annual rate of return of 6.75 percent Forever Savings, which is in the top corporate tax bracket of 35 percent, must pay an average interest rate of 4.25 percent to borrow the funds needed to purchase the municipals Would you recommend purchasing these bonds? Calculate the net after-tax return on this bank-qualified municipal security What is the tax advantage for being a qualified bond? Because these bonds were issued by a small governmental unit issuing less than $10 million in securities annually, the interest cost the bank has to pay to acquire the funds needed to buy these bonds is tax deductible Therefore, their net after-tax return is: Net after-tax return on municipals (in percent) =  Nominal return on municipals after taxes (in percent)   Interest expense incurred in acquiring the municipals (in percent)    + Tax advantage of a qualified bond Tax advantage of qualified bond =  The bank's marginalincome tax rate (in percent) ×   =  Percentage of interest expense that is still tax deductible×   Interest expense of acquiring the municipals (in percent)  10-13 Chapter 10 - The Investment Function in Financial-Services Management Net after-tax retrun = (0.0675 – 0.0425 ) + (0.35 × 0.80 × 0.0425) = 0.025 + 0.0119 = 3.69 percent This net yield figure should be compared with other investments of comparable risk on an aftertax basis If the municipal bond described above had come from a larger state or local government not eligible for special treatment under the Tax Reform Act, none of the interest expense would have been tax deductible and the net tax advantage to the bank purchasing the nonqualified bonds would be nil Hence, the tax-exempt status of the income coupled with the tax-deductibility of the interest expense makes these bonds a very attractive alternative 10-6 Forever Savings Bank also purchases municipal bonds issued by the city of Richmond Currently the bank is considering a nonqualified general obligation municipal issue The bonds, which mature in 15 years, provide a nominal annual rate of return of 9.75 percent Forever Savings Bank has the same cost of funds and tax rate as stated in the previous problem a Calculate the net after-tax return on this nonqualified municipal security Net after-tax return = 9.75 percent – 4.25 percent = 5.50 percent b What is the difference in the net after-tax return for this qualified security (Problem 5) versus the nonqualified municipal security? Net after-tax return (qualified security) – Net after-tax return (nonqualified municipal security) = = 3.69 percent – 5.50 percent = 1.81 percent Therefore, the net after-tax return from the qualified security is 1.81 percent less than the nonqualified municipal security c Discuss the pros and cons of purchasing the nonqualified rather than the bank qualified municipal described in the previous problem Clearly, the net after tax return for the nonqualified bond is higher than for the qualified bond On the other hand, nonqualified bonds are less liquid and thus, carry a higher liquidity risk They also tend to have a higher default risk, but that should already be priced into the yield of the bond 10-7 Lakeway Thrift Savings and Trust is interested in doing some investment portfolio shifting This institution has had a good year thus far, with strong loan demand; its loan revenue has increased by 16 percent over last year’s level Lakeway is subject to the 35 percent corporate income tax rate The investments officer has several options in the form of bonds that have been held for some time in its portfolio: a Selling $4 million in 12-year City of Dallas bonds with a coupon rate of 7.5 percent and purchasing $4 million in bonds from Bexar County (also with 12-year maturities) with a coupon 10-14 Chapter 10 - The Investment Function in Financial-Services Management of percent and issued at par The Dallas bonds have a current market value of $3,750,000 but are listed at par on the institution’s books b Selling $4 million in 12-year U.S Treasury bonds that carry a coupon rate of 12 percent and are recorded at par, which was the price when the institution purchased them The market value of these bonds has risen to $4,330,000 Which of these two portfolio shifts would you recommend? Is there a good reason for not selling these Treasury bonds? What other information is needed to make the best decision? Please explain Under option (A), Lakeway will take an immediate $250,000 ($4 million − $3.75 million) loss before taxes (or a loss of $162,500 after taxes) which can be used to help offset the high taxable loan income earned this year Moreover, the thrift will be able to earn percent on an investment of $4 million, or $320,000, in annual interest income compared to only $300,000 with the bonds currently held or a gain in tax-exempt income of $20,000 per year (Of course, if the thrift can only afford to buy $3,750,000 in new municipals (the sale price of the old bonds) it will generate about $300,000 in after-tax interest and have no net gain in tax-exempt interest income, but will still have a tax-deductible loss on the sale of the old bonds.) Under option (B), the U.S Treasury bonds must be sold for a gain of $330,000 which is taxable income Because Lakeway does not need additional taxable income, Option B is less desirable than Option A Besides, the Treasury bonds are selling at a premium above par which indicates their coupon rate is higher than current interest rates on investments of comparable risk, suggesting the wisdom of retaining these bonds in the bank's portfolio either until loan revenues decline and the bank needs additional taxable income or until interest rates rise well above current levels and new securities appear that promise significantly higher interest yields 10-8 Current market yields on U.S government securities are distributed by maturity as follows: 3-month Treasury bills 6-month Treasury bills 1-year Treasury notes 2-year Treasury notes 3-year Treasury notes 5-year Treasury notes 7-year Treasury notes 10-year Treasury bonds 20-year Treasury bonds 30-year Treasury bonds = = = = = = = = = = 1.90 percent 2.10 percent 2.25 percent 2.51 percent 2.82 percent 3.28 percent 3.56 percent 3.98 percent 4.69 percent 5.25 percent Draw a yield curve for these securities What shape does the curve have? What significance might this yield curve have for an investing institution with 75 percent of its investment portfolio in 7-year to 30-year U.S Treasury bonds and 25 percent in U.S government bills and notes with maturities under one year? What would you recommend to management? 10-15 Chapter 10 - The Investment Function in Financial-Services Management The yield curve for U.S Treasury bonds clearly slopes upward Like most yield curves, this curve does not become flat at longer maturities A financial institution with 75 percent of its portfolio in this 7- to 30-year range gains very little yield advantage over those institutions holding shorter maturities in the form of 3-month bills to 5-year notes Yet, the longer-term bonds are less liquid so that a bank holding 7+ year maturities faces substantially greater liquidity risk This bank would probably be better off shifting its portfolio from 75 percent in long-term securities into medium-term maturities 10-9 A bond possesses a duration of 8.89 years Suppose that market interest rates on comparable bonds were 7.5 percent this morning, but have now shifted downward to 7.25 percent What percentage change in the bond’s value occurred when interest rates decreased by 25 basis points? Δi (1 + i)  -0.0025  Percent Change in Value = -8.89 ×   = 0.02067 or 2.067 percent  + 0.075  Percentage change in price  -D × 10-10 The investments officer for Sillistine Savings is concerned about interest rate risk lowering the value of the institution’s bonds A check of the bond portfolio reveals an average duration of 4.5 years How could this bond portfolio be altered in order to minimize interest rate risk within the next year? Sillistine’s bond portfolio has an average duration of 4.5 years This is relatively long, subjecting them to substantial interest-rate risk Shortening the duration of the portfolio or the use of hedging tools (such as futures and options) is recommended 10-11 A bank’s economics department has just forecast accelerated growth in the economy, with GDP expected to grow at a 4.5 percent annual growth rate for at least the next two years What are the implications of this economic forecast for an investments officer? What types of securities should the officer think most seriously about adding to the investment portfolio? Why? Suppose the bank holds a security portfolio similar to that described in Table 10-3 for all insured 10-16 Chapter 10 - The Investment Function in Financial-Services Management U.S banks Which types of securities might the investments officer want to think seriously about selling if the projected economic expansion takes place? What losses might occur and how could these losses be minimized? This economic forecast suggests that the current yield curve should be upward sloping and that interest rates will rise over the next two years In addition, loan demand should increase as the economy expands suggesting that the bank may have to sell some of its investment portfolio in the future to meet that demand The investment officer would probably shorten the maturities of the investment portfolio An exception to this might be if the investment officer wants to ride the yield curve by selling shorter term securities at a premium today and replacing them with longer maturity securities with higher coupon rates However, the investment manager must take into account the risk of capital losses for the future with this strategy The investment manager can reduce his risks with the appropriate hedging tools as discussed in previous chapters 10-12 Contrary to the exuberant economic forecast described in problem 11, suppose a bank’s economics department is forecasting a significant recession in economic activity Output and employment are projected to decline significantly over the next 18 months What are the implications of this forecast for an investment portfolio manager? What is the outlook for interest rates and inflation under the foregoing assumptions? What types of investment securities would you recommend as good additions to the portfolio during the period covered by the recession forecast and why? What other kinds of information would you like to have about the bank’s current balance sheet and earnings report in order to help you make the best quality decisions regarding the investment portfolio? This economic forecast suggests that the current yield curve should be flat or downward sloping and interest rates and inflation should fall over the next 18 months In addition, loan demand should decline in the future as output and employment decline The portfolio manager should lengthen the maturities of the investment portfolio and lock in higher rates now However, the investment manager should look at the bank’s current interest-sensitive gap and duration gap position as well as their current earnings and tax status and consider these aspects of the bank’s balance sheet before making any decisions 10-13 Arrington Hills Savings Bank, a $3.5 billion asset institution, holds the investment portfolio outlined in the following table This savings bank serves a rapidly growing money center into which substantial numbers of businesses are relocating their corporate headquarters Suburban areas around the city are also growing rapidly as large numbers of business owners and managers along with retired professionals are purchasing new homes Would you recommend any changes in the makeup of this investment portfolio? Please explain why Types of Securities Held Percent of Total Portfolio U.S Treasury securities 38.7% Federal agency securities 35.2 Types of Securities Held Securities available for sale Securities with Maturities: 10-17 Percent of Total Portfolio 45.6% 11.3 Chapter 10 - The Investment Function in Financial-Services Management Under one year State and local government obligations Domestic debt securities Foreign debt securities Equities 15.5 5.1 One to five years 37.9 Over five years 50.8 4.9 0.6 This bank is going to experience increasing loan demand in the future This may mean increased taxes in the future, increased liquidity risk and increased credit risk from its loan portfolio To help with the liquidity risk, the bank may want to consider shifting some of its portfolio from securities with more than five years to maturity to shorter term securities In terms of the increased taxes and credit risk, it depends on which one of these is more important The proportion of the municipal bonds in this bank’s portfolio is already higher than the average bank of its size The bank may want to reduce its credit risk by reducing its state and local government (municipal) bond portfolio However, this bank does have other ways of reducing its credit risk and it may want to decrease its taxability by increasing its investment in municipal bonds 10-18 ... assets, hence providing flexibility to the banks Over and above, the bank managers can also dress up the balance sheet and make a financial institution look financially stronger due to the high quality... available to banks include U.S Treasury notes and bonds, municipal notes and bonds, and corporate notes and bonds The characteristics of these securities are their higher expected rate of return and capital... Function in Financial- Services Management 10-12 Suppose a corporate bond an investments officer would like to purchase for her bank has a before-tax yield of 8.98 percent and the bank is in the