Chapter 13 - Short-term Investing and Borrowing Flashcards
1
Q
What is the first step in managing a short-term investment portfolio?
A
Create the investment policy
2
Q
The objectives of an investment policy reflect the organization’s philosophy about what?
A
Risk and return
3
Q
Three Core Objectives when Investing
A
Preserve principal (safety objective)
Retain access to invested funds (liquidity objective)
Achieve a return (yield objective)
4
Q
Risks to be considered when making investments
(review)
A
- Credit risk
- Counterparty risk
- Interest rate risk
- Reinvestment risk
- Repayment risk
- FX risk
- Sovereign risk
5
Q
How many of the three core investment objectives can be targeted at once?
A
Only two
6
Q
Four Risk Types for Short-Term Investments
A
Default/Credit Risk – likelihood payments will not be made under the original terms
Liquidity Risk – security cannot be sold quickly without incurring a substantial loss
Interest Rate Risk – reinvestment risk and price risk
Foreign Exchange Risk – risk that the value of the investment will decline due to changes in foreign exchange rates
7
Q
What are the two primary determinants associated with liquidity risk?
A
Marketability and maturity
8
Q
What are the two components of interest rate risk?
A
Reinvestment Risk - potential for lower interest rates when maturity occurs
Price Risk - change in interest rates will impact price; usually refers to the risk of an increase in rates
9
Q
Which securities have a greater exposure to interest rate risk?
A
Long-term securities
10
Q
A depreciation of the foreign currency investment will result in what?
A
A lower return on investment for the investor
11
Q
Is FX risk present regardless of sales prior to maturity or at maturity?
A
Yes, it doesn’t matter
12
Q
What are some examples of ways entities may limit foreign exchange risk in their portfolios?
A
Require investment to be in an economically and politically stable country
Suitable as part of an overall currency hedging program
13
Q
What are examples of regulatory or legal restrictions that should be incorporated in investment making decisions?
A
Insurance company regulations
Debt covenants
Statutory guidelines
14
Q
Buy-and-Hold-to-Maturity Investment Strategy
(describe three core components)
A
“Traditional” investment strategy
Three components:
* Invest in securities whose maturities can fund cash needs
* Hold securities to maturity
* Only reinvest if funds are not needed for expenditures
15
Q
Buy-and-Hold-to-Maturity Investment Strategies are also known as what?
(and what will firms try to do in order to minimize risk?)
A
Maturity matching strategies
Firms will oftentimes only cover a portion of the expected capital due to potential changes that can occur with the forecast
16
Q
Downside to Buy-and-Hold-to-Maturity strategies?
A
Forego potentially more lucrative investment options
Changes in forecasts
17
Q
Active Investment Strategy
(also known as…)
A
Total-return strategy
Maximize capital gains
18
Q
When is an active investment strategy most suitable to use?
A
For medium or longer-term investment portfolios
19
Q
Capital gains are possible under an active investment strategy when which core market principle exists?
A
The rate curve must be positive sloping
20
Q
Tax-Based Investment Strategy
A
Strategies designed to minimize tax returns
21
Q
Methods used under the Tax-Based Investment Strategy
A
Municipal bonds
Tax-advantaged MMFs
Dividend capture
22
Q
What is the dividend capture tax-motivated investment strategy?
A
- So long as a company owns stock for at least 46 days of the 91 day period starting 45 days prior to the ex-dividend date, it can exclude 70-80% of that dividend
- It is seen as a short-term investment even though there is no maturity on the equity stock
- Gains and losses from subsequent sales are targeted to offset
- Not a good strategy during times of economic downturn or political/economic instability
23
Q
Controls for In-House Investment Management
(review)
A
- Delegation-of-authority matrix
- Methods of monitoring compliance with policies, procedures, and internal controls
- Provisions for performance measurement, evaluation, and reporting
- Exception management and related approval processes
- Strict segregation between investment analysts and investment managers
24
Q
Advantages and Disadvantages of In-House Investment Management
A
Advantages
* maintain control over the investment process
Disadvantages
* Design and implementation of controls
* Costly to hire, train, and retain employees
25
Advantages and Disadvantages of Outsourced Management for Investment Portfolios
**Advantages**
* Greater resources
* Better experience
**Disadvantages**
* Misalignment with investment policy and actions taken by manager
* Compliance and due diligence with the investment manager
* Incentive structure faced by the outside investment manager may not align with the company’s goals
26
Broker-Dealers vs. SMA Managers for Risk
| (fiduciary duty)
Broker-dealers do not have a fiduciary responsibility by themselves
SMA managers do
27
What is one of the best methods to compare investment manager performance?
Choosing a benchmark rate to compare against
May be more helpful than just comparing between investment managers
28
Combination of In-House and Outsourced Management
Treasury places short-term investments
External managers focus on medium and long-term investments
29
Shot-Term Investment Valuation and Impairment Policies are applicable to what types of securities?
Anything beyond cash and cash equivalents
30
Short-Term Investment Valuation Policy
Lays out the methodology that will be used to establish the fair market value of the securities
Very important when securities are not actively traded
31
Short-Term Investment Impairment Policy
Documents the actions that will be taken when a particular investment becomes impaired
Address severity and duration
Does not require a write-down, but a quantitative analysis should be performed
32
Securities held with custodians are held in what form?
Street name
In the firm’s name on behalf of the investor
33
Two Typical Choices for Custodial Services Set-Up
Find an independent custodian that will collaborate with the broker
Broker’s firm may offer custodian services at little to no charge
34
Two primary advantages of consolidating securities custody?
Reporting is consolidated
Control is established over all investment portfolios
35
Requiring brokers to work with an independent custodian helps to establish what?
Segregation of duties
36
Impaired Security Definition
Fair value is below its adjusted cost basis
37
Other-Than-Temporary-Impairment (OTTI) Impact on Financials
Loss must be subtracted from investment earnings
38
Common Benchmarks for USD Investments
* SOFR
* Yields on US Treasuries
* 30-day commercial paper
Blended benchmarks may be best depending on portfolio composition
39
Ideally, who should be in charge of performing a compliance review of the investment policy?
Internal or external audit
Compliance department that is outside the policy-related functional area
40
Which functions should be separated to ensure proper segregation of duties as it relates to investments and compliance?
| (3 Examples)
Investment authority and recordkeeping should be separate
Investment manager should be separate from the accounting function
Investment manager should be separate from those processing the transactions
41
What is an example of a safeguard control that accounting performs as it relates to investments?
Monthly reconciliations
42
An investment policy should specify any limitations that a firm may have regarding the maximum and average duration of the investments in its portfolio. This exposure horizon is a function of both the organization’s XXXXXXXXXX and the XXXXXXXXXX?
Risk philosophy
Total interest rate exposure already present in other areas of the organization
43
Investment Time Horizon
Total length of time that an investment will be held before the investment matures or is sold
44
An investment report should clearly illustrate the composition of a portfolio according to:
| (three classifications)
* Maturity distribution
* Quality ratings
* Security classes
45
What is the primary downside to having a broker use its own custodian?
May create an unacceptable fraud risk
46
Term Structure
| (Short-Term Investments & Yield)
Curve in the graphs of the various yields
47
Why are longer-term investments normally associated with higher yields?
Greater risk is being taken by the investor
Lower liquidity
48
An inverted yield curve can imply two things:
Investors are seeking longer-term investments
Investors have had to liquidate short-term investments and become short-term borrowers
49
When the Fed decides to target short-term rates and increases rates, what happens first?
Short-term borrowings will increase, but longer-term securities will lag behind
50
Expectations of high inflation lead to what with regards to yield?
A higher yield due to higher investor expectations
51
Short-Term Investment Yield is a function of what?
| (Three Items / Think of the Formula Components)
1. Cash Flows Received
2. Amount Paid
3. Maturity or holding period
52
Days Count Convention
The number of days used in various yield calculations
53
Rate quotes and interest payments for money market funds are based off of which days count convention?
360
54
Effective Annual Yield is usually calculated based off of which days count convention?
365
55
The standard convention for a given instrument type is rooted in?
Historical practice
56
What is the basis that is used when investments are held less than a month?
| (Term & Definition)
Actual basis
The actual number of days in the month the security was held
57
Money Market Yield (MMY) vs. Bond Equivalent Yield (BEY)
| (Days Count Conventions)
MMY = 360 days
BEY = 365 days
58
What needs to occur to transition the Holding Period Yield to the MMY or BEY yield?
It needs to be annualized
59
Which yield will be higher, the MMY or the BEY?
The BEY because there are more periods in a 365-day year than there are in a 360-day year
Smaller portion of time to earn the income in a 365-days year compared to a 360-day year
60
Dollar Discount
The difference between the par value and the purchase price
61
Why will BEY/MMY always exceed the discount rate?
The discount rate utilizes the full par value in the denominator while the others use the purchase price
62
The discount rate is annualized on what days count convention?
360
63
Bid vs. Ask Quotes in T-Bill Quotations
Bid = Buy
Ask = Sell
64
Bid and Ask quotes are calculated using which days count convention? Why?
360
Discount calculation
65
The Ask Yield is calculated using which convention?
The BEY using the 365 days count convention
66
The Ask Yield represents what?
The yield to the investor that is purchasing at the broker’s ask pricing
67
Treasury Securities Pricing is usually presented as which three metrics?
* Bid Discount
* Ask Discount
* Ask Yield
68
Nominal Yield
the fixed interest rate a bond pays to investors, expressed as a percentage of the face value
69
When needing to calculate the holding period yield when provided the BEY or MMY, remember this shortcut...
| (which formula should be used)
Holding Period Yield X (36X/DTM) = BEY/MMY
Solve with algebra to get the Holding Period
Holding Period = BEY/MMY x (DTM/3X)
70
Short-term debt instruments are usually used to finance what?
Current assets like accounts receivable and inventory
71
What is a key requirement for intercompany lending?
Involve promissory notes or memorandum of understanding
72
How are intercompany loans generally priced?
Arm’s length pricing
73
Intercompany loans have which benefits for all counterparties involved?
Borrowers benefit from lower cost of funds
Lender will typically generate higher return than if the surplus cash was placed in MMFs
74
Two options for selling off receivables
Factoring
Securitization
75
Discounted invoice terms as part of supply chain management are determined using which rate?
The buyer’s cost of capital
76
In supply chain financing, a supplier receives XXXXX based on the credit rating and financial capabilities of their XXXXXX
Loans (early settlement of A/R)
Customers
77
Credit facilities
Loans and credit arrangements
78
How many promissory notes are there in loan syndications?
One promissory note for each lender
Shared documentation
79
Are loan syndications considered indirect or direct lending relationships?
Direct, because each lender has its own promissory note
80
How is a loan syndicate organized?
One agent will act as the intermediary and receives annual fees
Remaining syndicate members
81
Loan Syndication vs. Loan Participation
Syndication – multiple financial institutions share the funding of a single credit facility
Participation – other financial institutions purchase an interest in one lender’s facility
82
Participant vs. Lead Institution
| (Loan Participation)
Participant = purchaser
Lead Institution = seller
83
Are loan participations considered indirect or direct lending relationship?
Indirect, there is only one promissory note
84
Blind Participation
Participation is not disclosed to the borrower and the participant may not contact the borrower directly or disclose
85
What governs a loan participation arrangement?
A participation agreement
86
What are swing or bridge loans?
Designed to provide short-term funding until longer-term financing can be arranged
87
Sub-limits for Lines of Credit
Letter of credit
Banker’s acceptances
Borrowing in foreign currencies
88
While covenants are often required as part of short-term borrowing, they are also a useful what type of tool?
Management tool
Helpful for communicating issues in advance with strong forecasting
89
Borrowing Base
| (Short-term borrowing) (aka)
Also known as the loan value
Negotiated as a percentage of the value of the collateral securing the line
90
Uncommitted vs. Committed Lines of Credit
Uncommitted – lender offers to make funds available, but is not obligated to provide a specific amount; can cancel at any time
Committed – includes detailed loan agreement to outline specifics; usually pay commitment fees for used and unused portion
91
What is an accordion feature for a line of credit?
Allows it to expand up to a pre-negotiated limit for a period of time
92
Revolvers are usually secured by what?
General claims on the liquid assets of the client
93
Most revolvers are committed or uncommitted?
Committed
94
If more than one year remains on a revolver balance, accounting guidance usually lets the firm classify the debt as what?
Long-term
95
What may happen at the end of a revolver term?
May be converted to more traditional loan where principal is paid back over time
96
In addition to all the features of a committed line, revolvers will often include what?
Short-term fixed-rate funding options with penalties for prepayment
97
Guidance Line / Operating Risk Exposure Limit
Accommodate credit exposures created from operating activities like daylight overdraft, ACH operations, etc.
98
How do banks treat guidance lines?
They view them as a credit exposure that impacts overall lending, but it does not represent a commitment to provide funding
Helps to provide all-encompassing picture of the customer in terms of exposure
99
Are guidance lines usually disclosed?
No
100
Overdraft Facilities
Similar to guidance lines, but more formalized to allow negative balances
101
Pricing for a Line of Credit
| (3 Components & which are recurring?)
All-in rate of interest (Recurring)
Commitment fees (used and/or unused) (Recurring)
Upfront and arranger fees (initial and renewal) (May or may not be recurring)
102
Single Payment Notes
Usually very short term with a specific purpose
Both principal and interest paid at maturity
103
What is an equivalent to a repurchase agreement that achieves the same purpose?
Single payment note secured by marketable securities
104
CP issuances oftentimes require that the issuer also have what in place?
A credit facility in case they are not able to continually reissue commercial paper
105
Two options for placing commercial paper
Directly or through a dealer
106
Are commercial paper issuances usually large or small?
Usually large
Companies want to make sure the issuance makes economic sense as it can be more expensive than obtaining commercial bank credit
107
Asset-based borrowing usually relies on what type of collateral?
Inventory and accounts receivable because it is most liquid
108
Three Costs for Issuing CP
Interest rate implied in the discount
Dealer fee
Fee for credit enhancement (backup or standby line of credit)
109
Why is the CP Nominal Yield to the investor different than the Annualized Cost to the issuer?
Will it be higher or lower?
CP Nominal Yield will be lower because it does not receive the dealer or backup L/C fees that are calculated in the annual cost
110
If a facility can be cancelled at any time, it is committed or uncommitted?
Uncommitted
111
What happens if a member of a loan syndicate wishes to exit the syndicate? What happens to the line?
Individual lenders in the syndicate are usually able to sell their shares with or without consent from the borrower, depending on the terms of the contract
The overall line is unaffected as it is assigned to a new lender or reassigned among the remaining syndicates
112
3(A)(3) vs. 4(A)(2) Commercial Paper Offerings
3(A)(3) – Public, working capital only, 270 days, $100,000, accredited investors
4(A)(2) – Private, no restrictions, 397 days, $250,000, institutional investors and QIBs
113
Basic Components of Interest Rates
Cost of Debt =
Real Risk-Free Rate +
Inflation Premium (IP) +
Default Premium (DP) +
Liquidity Premium (LP) +
Maturity Premium (MP)
114
Real Risk-Free Rate
The rate demanded by lenders to compensate for delaying their use of the money today, in the absence of any risk or inflation, for one year
115
What is a substitute for the real risk-free rate?
T-bills adjusted for inflation
116
Nominal Rate
| (What two interest rate components are included in this rate?)
Real Risk-Free Rate + Inflation Premium
117
Base Rate vs. Spread Interest Rate Components
Base Rate = inflation and maturity
Spread = default and liquidity
118
Why are benchmark rates higher than T-bill rates?
They include a tiny component for default risk
119
When replacing LIBOR, regulators and market participants had to choose from three options:
Adopting an existing benchmark rate
Reforming an existing benchmark rate
Developing a new benchmark rate
120
SOFR and SARON are what types of benchmark rates
Based on secured transactions (repos)
121
Federal Funds Rate vs. Effective Federal Funds Rate
Federal Funds Rate = Set by FOMC; cost to borrow reserve balances from one another
Effective Federal Funds Rate = rates actually charged by the banks
122
US Prime Rate
Typically set ~3% points higher than the Federal Funds Rate
Offered to best corporate customers
123
Does US Prime fluctuate frequently?
No
124
Is it usually possible to find financing below US Prime?
Yes
125
Borrowing on a short-term basis carries with it two primary risks:
Fluctuations in market interest rates
Availability of funds (credit tightening)
126
Operational Advantages of Short-Term Financing
Ease of access
Flexibility
Ability to efficiently finance seasonal credit needs
Less restrictive covenants
127
Spontaneously Generated Financing
Accounts payables and accruals
128
Operational Disadvantages of Short-Term Financing
Need to renegotiate or roll over the financing
Cleanup period restricts access to funds
129
Lower-risk option to finance current assets (and downsides)
Asset-based lending
Assets must be monitored for asset deterioration
Key rates must be maintained
Limited to percentage of assets
Secured borrowing takes time to negotiate
130
Negative and Positive covenants are also known as:
Restrictive and affirmative covenants
131
If you are going to use a small/large portion of a line, how would you want to negotiate rates?
Small = larger interest rate, smaller commitment
Large = small interest rate, larger commitment
132
An investor’s effective annual yield will be calculated using which days convention?
365
133
ESTER/ESTR
Risk-free reference rate for the ECB
134
What types of things will the issue-specific credit rating take into account?
Issuer credit rating
Collateral quality
Terms of the issue
Creditworthiness of guarantors
135
Maturities for Treasury Bills, Notes, and Bonds
* Bills = less than 1 year
* Notes = 2 to 10 years
* Bonds = greater than 10 years
136
What provides a tangible economic benefit because it is a way to avoid incurring debt or liquidating investments?
Trade credit
137
How often are ratings usually reviewed by CRAs?
Annually
138
Is a Eurobond rate able to be used as a base rate?
No
