EKRP311 > Chapter10 > Flashcards

Chapter10 Flashcards

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1
Q

Why do depository institutions devote a significant portion of their asset portfolio to another major earning asset like investing in securities?

A

Loan income is taxable, necessitating the search for tax shelters in years when earnings from loans are high.

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2
Q

List the different kinds of characteristics expressed by investment instruments available to financial firms.

A

-expected yields
-risk
-sensitivity to inflation
-sensitivity to shifting government policies and economic conditions.

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3
Q

List the two categories of investment instruments available to financial firms.

A
  • Money market instruments
  • Capital Market Instruments
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4
Q

What are the characteristics of money market instruments?

A

-Reach maturity in one year
- Low risk
- Ready Marketability

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5
Q

What are the characteristics for capital market instruments?

A

▫ Maturity Beyond One Year
▫ Higher Expected Rate of Return
▫ Capital Gains Potential

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6
Q

List the functions of a bank’s investment security portfolio.

A

a. Stabilize income, so that revenues level out over the business cycle-when loan revenues fall, income from investment securities may rise.
b. Offset credit risk exposure in the loan portfolio. High-quality securities can be purchased and held to balance out the risk from loans.
c. Provide geographic diversification. Securities often come from different regions than the sources of loans, helping diversify a financial firm’s sources of income.
d. Provide a backup source of liquidity, because securities can be sold to raise needed cash or used as collateral for borrowing additional funds.
e. Reduce tax exposure, especially in offsetting taxable loan revenues.
f. Serve as collateral (pledged assets) to secure federal, state, and local government deposits held by a depository institution.
g. Help hedge against losses due to changing interest rates.
h. Provide flexibility in a financial firm’s asset portfolio because investment securities, unlike many loans, can be bought or sold quickly to restructure assets.
i. Dress up the balance sheet and make a financial institution look financially stronger due to the high quality of many marketable securities .

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7
Q

List money market instruments used by a bank.

A
  • 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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8
Q

What are the advantages of Treasury Bills?

A
  • They are attractive to financial firms because of their high degree of safety and liquidity.
    -They can serve as collateral for attracting funds from other institutions.
    -Can pledge behind government deposits
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9
Q

What is the disadvantage of treasury bills?

A

Low yields relative to other financial instruments.
Taxable income

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10
Q

What are the advantages of short-term treasury notes and bonds?

A

-Their expected returns are usually higher than for bills with greater potential for capital gains.
- They can be resold easily.
-They can serve as collateral for attracting funds from other institutions.

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11
Q

What is the disadvantage of short-term treasury notes and bonds?

A

-more sensitive to interest rate risk and less marketable than T-bills
- Taxable gains and income

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12
Q

What are the advantages of Banker’s acceptance ?

A
  • Low risk due to multiple credit guarantees
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13
Q

What are the disadvantages of banker’s acceptance?

A

-Limited availability at specific maturities.
-Taxable income

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14
Q

What is the advantage of commercial paper?

A
  • Low risk due to high quality of borrowers.
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15
Q

What is the disadvantage of commercial paper?

A
  • Volatile market
  • Poor resale market
  • Taxable income
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16
Q

What is the advantage of short-term municipal obligations?

A
  • Tax exempt interest income
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17
Q

What is the disadvantage of short-term municipal obligations?

A
  • Taxable capital gains
  • Limited resale market
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18
Q

What are the advantages of international eurocurrency deposits?

A

-Low risk
- Higher yields than on many domestic CDs

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19
Q

What are the disadvantages of international Eurocurrency deposits?

A
  • Volatile interest rates
    -Taxable income
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20
Q

List capital market instruments used by a bank.

A
  • Treasury Notes and Bonds Over One Year to Maturity
  • Municipal Notes and Bonds
  • Corporate Notes and Bonds
  • Asset Backed Securities
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21
Q

What are the advantages of Treasury Notes and Bonds.

A
  • They have a good resale market
  • Good collateral for borrowing
  • May be pledges behind government deposits
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22
Q

What are the disadvantages of Treasury Notes and Bonds.

A
  • Low yields relative to long-term private securities
  • Taxable gains and income
  • Limited supply of longest-term issues
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23
Q

What are the advantages of Municipal bonds.

A
  • Tax-exempt interest income
  • High credit quality
  • Liquidity and marketability of selected securities
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24
Q

What are the disadvantages of Municipal bonds.

A
  • Volatile Market
  • Some issues have limited resale potential
  • Taxable capital gains
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25
What are the advantages of corporate notes and bonds.
- Higher pretax yields than on government securities - Aid in locking in higher long-term rates of return
26
What are the disadvantages of corporate notes and bonds?
-Limited resale market - Inflexible terms - Taxable gains and income
27
What are the advantages of Asset-backed securities?
- Higher pretax yields than treasury securities - Collateral for borrowing additional funds
28
What are the disadvantages of Asset-backed securities?
- Less marketable and more unstable in price than treasury securities -May carry substantial default risk -Taxable gains and income
29
What are the factors affecting the choice of securities?
* Expected Rate of Return * Tax Exposure * Interest Rate Risk * Credit Risk * Business Risk * Liquidity Risk * Call Risk * Prepayment Risk * Inflation Risk * Pledging Requirements
30
How do interest rates affect the choice of securities?
* Rising Interest Rates Lowers the Value of Previously Issued Bonds * Longest –Term Bonds Suffer the Greatest Losses
31
What tools are used to hedge interest rate risks?
-Financial Futures -Options -interest rate Swaps Exist
32
What is business risk?
Risk that the economy of the market area they serve may turn down, with falling sales and rising unemployment.
33
Where is business risk reflected?
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.
34
How do financial institutions offset the impact of this risk?
-Thy rely heavily on their security portfolios -This usually means that many investment securities purchased will come from borrowers located outside the principal market for loans.
35
What is the key issue that a portfolio manager must face in selecting a security for investment portfolios with regard to liquidity risk?
The breadth and depth of its resale market( secondary market). Which is given by the number of traders and the volume of trades on any given day.
36
What securities are generally the most liquid?
Treasury securities
37
How does call risk affect the choice of securities?
-Many corporations and some governments that issue securities reserve the right to call in those instruments in advance of maturity and pay them off. - Because such calls usually take place when market interest rates have declined, 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
38
How do investors minimize call risk?
By purchasing callable instruments bearing longer call deferments (so that a call cannot occur for several years) or simply by avoiding the purchase of callable securities.
39
What is prepayment risk?
A form of risk specific to asset-backed securities. This form of risk arises because the realized interest and principal payments ( cash flow) from a pool of securitized loans may be quite different from the cash flows expected originally
40
What do the variations in cash flow to holders of the securities backed by these loans arise from?
1. Loan refinancings, which tend to accelerate when market interest rates fall(in this case borrowers may realize they will save on loan payments if they replace their existing loans with new lower-rate loans). 2. Turnover of the assets behind the loans (in this case borrowers may sell out and move away or some borrowers may not be able to meet their required loan payments and default on their loans).
41
How does inflation risk affect the choice of securities?
Investing institutions must be alert to the possibility that the purchasing power of interest income and repaid principal from a security or loan will be eroded by rising prices for goods and services.
42
How is protection against inflation provided?
-By short-term securities and those with variable interest rates, which usually grant the investments officer greater flexibility in responding to any flare-up in inflationary pressures. -Both coupon payments and principal adjusted Annually for inflation based on Consumer Price Index as provided by the Treasury Inflation-Protected Securities.
43
List the different forms of 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
44
Describe the ladder or spaced maturity policy.
Maximum acceptable maturity is chosen and then invest in equal proportion of securities in each of several maturity intervals until maximum acceptable maturity is reached.
45
What is the strategy for the ladder or spaced-maturity policy?
Divide investment portfolio equally among all maturities acceptable to the investing institution.
46
What are the advantages for the ladder or spaced-maturity policy?
-Reduces investment income fluctuations -Requires little management expertise.
47
Describe The Front-End Load Maturity Policy.
Only short-term securities are purchased and all investments are placed within a brief interval of time.
48
What is the strategy for The Front-End Load Maturity Policy?
All security investments are short-term.
49
What are the advantages of The Front-End Load Maturity Policy?
Strengthens the financial firm's liquidity position and avoids large capital losses if market interest rates rise.
50
Describe The Back-End Load Maturity Policy.
- Stresses the investment portfolio as a source of income. -An investing institution following the back-end load approach might decide to invest only in bonds in the 5- to 10-year maturity range. - This institution would probably rely heavily on borrowing in the money market to help meet its liquidity requirements.
51
What is the strategy used by The Back-End Load Maturity Policy.
All investments are long term
52
What are the advantages for The Back-End Load Maturity Policy.
Maximizes income potential from security investments if market interest rates fall.
53
Describe The Barbell Strategy.
-A combination of the front-end and back-end load approaches, frequently employed by smaller financial firms 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 bonds at the other extreme, with minimal investment holdings in intermediate maturities. -The short-term portfolio provides liquidity, while the long-term portfolio is designed to generate income.
54
What is the strategy used by The Barbell Strategy.
Security holdings are divided between short-term and long-term.
55
What are the advantages of The Barbell Strategy?
Helps to meet liquidity needs with short term securities and to achieve earnings goals due to higher potential earnings from the long term portion of the portfolio.
56
Describe The Rate-Expectations Approach.
-The most aggressive of all maturity strategies, often used by the largest financial firms, - continually shifts maturities of securities in line with current forecasts of interest rates and the economy. - calls for shifting investments toward the short end of the maturity spectrum when interest rates are expected to rise and toward the long end when falling interest rates are expected.
57
Give reasons as to how investing institutions are inclined to trade securities.
(a) their expected after-tax returns can be raised through effective tax management strategies (b) higher yields can be locked in at the long-term end of the yield curve when the forecast is for falling interest rates; (c) the trade would contribute to an overall improvement in asset quality that would enable the institution to better weather an economic downturn (d) the investment portfolio can be moved toward higher-grade securities without an appreciable loss in expected return
58
Give the strategy for The Rate-Expectations Approach.
Change the mix of investment maturities as the interest-rate outlook changes
59
What is the advantage for The Rate-Expectations Approach.
Maximizes the potential for earnings (and also for losses)
60
How is the yield curve used as maturity management tool?
▫ 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 TradeOff
61
How is duration used as maturity management tool?
▫ Present Value Weighted Average Maturity of the Cash Flows ▫ Can Be Used to Insulate the Securities From Interest Rate Changes
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