im20 - Chapter 20 Active Investment Strategies Chapter...

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Chapter 20 Active Investment Strategies Chapter Objectives 1. Compare the laddered maturity strategy with the barbell (long and short) strategy when determining the appropriate maturity for new security purchases. 2. Discuss the advantages and disadvantages of active versus passive investment strategies. 3. Describe maturity strategies to ride the yield curve using total return analysis. 4. Examine the relationship between interest rates and the business cycle. Indicate why contra-cyclical investment strategies often provide the highest returns. 5. Describe how prices of securities with embedded options are affected by changing interest rates. Explain how effective duration and convexity can be used to assess price volatility. 6. Introduce option-adjusted spread (OAS) as a measure of incremental return. 7. Explain how the Tax Reform Act of 1986 changed the tax treatment of municipal bonds and affected the comparison of after-tax yields on taxables and municipals. 6. Describe the strategies underlying security swaps and leveraged arbitrage. Key Concepts 1. Laddered maturity strategies are passive because they require little analysis or expertise. They produce yields that represent average interest rates over the investment horizon. The barbell strategy requires that investors concentrate their security holdings either short-term for liquidity purposes or longer-term for yield. In most cases, the barbell strategy produces higher average yields than the laddered strategy. 2. Active portfolio management involves taking risks to improve returns. Specific strategies involve altering the maturity/duration of investments in anticipation of rate moves, swapping securities for yield, tax, or default risk reasons, and occasionally liquidating discount bonds to reinvest at higher rates. Generally, banks that follow active strategies classify most securities as available for sale because they may want to sell the instruments prior to maturity. 3. Interest rates and the level of economic activity vary coincidentally over time. Interest rates rise when aggregate spending rises and borrowers compete for financing. Interest rates fall when spending and borrowing pressures decline. Movements in short-term rates typically exceed movements in long-term rates. 4. Contra-cyclical investing requires that banks increase the size of their investment portfolio and lengthen maturities when loan demand is high. This generally coincides with peaks in the level of interest rates. The cost is that some loan customers are rationed out of the market and the bank may lose them as permanent customers. When loan demand is low, banks should stay short-term with investments because rates are generally low and will likely increase. Such investment timing should enable banks to lengthen security maturities when interest rates are relatively high and thus earn above-average coupon interest. 5. Riding the yield curve involves buying securities with a maturity longer than the bank’s (investor’s) holding
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im20 - Chapter 20 Active Investment Strategies Chapter...

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