im19 - Chapter 19 The Investment Portfolio and Policy...

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Chapter 19 The Investment Portfolio and Policy Guidelines Chapter Objectives 1. Describe the bank’s role as a securities dealer and in managing a trading account. 2. Explain the objectives of the investment portfolio. 3. Describe the composition of the average bank’s investment portfolio. 4. Examine the characteristics of securities comprising the investment portfolio. 5. Explain the nature and impact of prepayment risk in mortgage-backed securities. 6. Describe the nature of the market for asset-backed securities and provide an example of an asset-backed security. 7. Summarize basic investment policy guidelines. Key Concepts 1. Banks perform three functions within trading activities. They offer investment advice, maintain an inventory of securities to sell and stand willing to buy securities, and they speculatively trade securities for the banks own account. 2. The fundamental objectives of the investment portfolio are: a. safety or preservation of capital b. liquidity c. yield d. diversification of credit risk e. to help manage interest rate risk exposure f. to meet pledging requirements 3. Banks earn profits from trading activities by charging higher prices for securities sold than what they pay for the securities, and charging fees (requiring compensating balances) for investment advice, and guessing correctly when speculating on interest rates. Banks earn a return on investment securities in the form of coupon interest and capital gains (losses). 4. Banks must classify securities that they buy at the time of purchase into one of three categories based on the objective underlying the purchase. Trading account securities are those held briefly with the intent to sell. Held to maturity securities are those the bank expects to own until they mature. Available for sale securities are those the bank may choose to sell prior to maturity. Each category has a different accounting treatment regarding what is reported on the balance sheet (cost or market) and income statement. 5. Over time, banks have decreased their holdings of U.S. Treasury and municipal securities substituting agency and corporate/foreign securities. The most popular agency securities are different forms of mortgage-backed securities. The larger the bank, the smaller is the size of the investment portfolio relative to total assets. The largest banks, in turn, own more agency and corporate securities and other securities. Small banks own proportionately more U.S. Treasury and municipal securities. 6. Many banks buy taxable agency and mortgage-backed securities with embedded options. The most common agency security with options is a callable bond. The call feature allows the issuer the call the bond (pay the principal) prior to maturity at its discretion. This is risky to an investor because the bond’s price will not rise much above the call price when rates fall and the issuer will prepay the bond when rates fall to refinance at lower rates. Thus, the investor loses the above market coupon interest that might have been earned on a bond without
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This note was uploaded on 04/14/2010 for the course BANK 2312 taught by Professor William during the Spring '09 term at 東京大学.

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im19 - Chapter 19 The Investment Portfolio and Policy...

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