Topic 8 - Managing Securities Flashcards
financial asset
A financial asset is an intangible claim or right to receive future cash flows
real asset
which is a physical asset that has value, which can be used to general cash flows, but which does not in any sense represent a claimon future cash flows
security
A securityis a particular type of financial asset
A security is a financial asset that can be sold in a secondary market
Hence, all securities are financial assets, but not all financial assets are securities
a security has certain distinguishing features, compared to financial assets that are not securities:
Securities are purchased outright in financial markets, whereas investments such as loans are created through customer relationships
As a result, investments in securities can be achieved very quickly, and divested just as quickly
Securities can therefore be used as a “quick fix” to remedy problems on the balance sheet
ADIs are price takersin the securities markets
The yieldon a security represents
The yieldon a security represents the rate of return (for the investor) or the cost of borrowing (from the point of the view the issuer)
The main types of risk that an ADI needs to take into account when constructing its securities portfolio are:
1.Credit or default risk
- Liquidity or marketability risk
- Interest rate risk
- Purchasing power risk
- Portfolio risk
Credit or default risk
This is the risk that the issuer of a security will not pay interest or repay the principal on maturity
Liquidity or marketability risk
his is related to the liquidity of the market in which the security is traded, which in turn is a function of the number of buyers and sellers
Interest rate risk
This refers to the variability in returns as a result of changes in the general level of interest rates
There are two components of interest rate risk, which affect overall returns in opposite ways:
Price risk –the variability in the price or value of a security as a result of changes in interest rates
Reinvestment risk –the variability in returns caused by changes in the interest rate at which cash flows from a security can be reinvested
Purchasing power risk
This is variability in the purchasing power of those future cash flows due to changes in the rate of inflation
Portfolio risk
This refers to the risk of a diversified portfolio of securities, rather than individual securities
The main examples of Short Term Securities in an ADI’s portfolio are:
- Treasury notes
- Semi-government promissory notes
- Negotiable Certificates of Deposit (NCDs)
- Corporate promissory notes (commercial paper)
- Bank-accepted bills
- Repurchase agreements
Discount securities
Almost all short-term securities are discount securities, which means that they don’t make interest payments over the life of the security
Promissory notes
This is essentially nothing more than a promise to repay the funds borrowed –it is enforceable in the courts but there is no guarantee offered
Treasury notes
These are promissory notes (discount securities) issued by the Commonwealth government to meet its short-term funding requirements
Semi-government promissory notes
These are similar to treasury notes, but are issued by state and local governments to raise short-term funding
Negotiable Certificates of Deposit (NCDs)
A CD is a bank deposit that is documented by a certificate specifying the interest rate and maturity date, and an NCD is a CD that can be traded in a secondary market (as a security)
Corporate promissory notes
The are unsecured and therefore can only be issued by high-rated borrowers –small companies and companies without a very high credit rating need to use other means to raise capital, such as bank bills or bank loans
bill of exchange
A bill of exchangeis a short-term discount security, but it differs from a promissory note in one important respect –rather than a simple promise by the borrower to repay the borrowed funds, there is a third party which guarantees repayment
The three parties to a bill of exchange are:
DRAWER
ACCEPTOR
DISCOUNTER
DRAWER
Thisisanothernameforthe borrower.Thedrawer“draws up”aninstructiontothe acceptortopaytheholderof thebillasumofmoney(the facevalue)on aparticulardate inthefuture.
ACCEPTOR
Theacceptor“accepts”the instruction(inreturnforan acceptancefee,whichispart oftheborrower’scostof borrowing).Thisturnsthebill intoamarketablesecurity.
DISCOUNTER
Thedrawercanthenborrow bysellingthesecuritytoa discounter–another namefor thelender.Thediscounter paysadiscountedamount(less thanthefacevalue)toreflect thetimevalueofmoney.
When the bill matures:
The acceptor is liable to pay the face value of the bill to the holder of the bill (which may be the original discounter or someone else to whom the bill has been sold)
The acceptor then has a claim against the drawer (the original borrower)
If the bill is sold by the discounter into the secondary market prior to maturity:
Each person who sells the bill must endorsethe bill, thereby incurring a contingent liability
This means that if the acceptor and drawer both default, the holder of the bill then has a claim against those who have sold (and hence endorsed) the bill
Bank-accepted bills
If the acceptor of the bill is a bank, the increases the marketability of the bill, and it is known as a bank-accepted bill (or BAB)
Repurchase agreements
Under a repurchase agreement, an asset is sold subject to an agreement that the seller will repurchasethe asset in the future
The main examples of long-term securities in the securities portfolio or an ADI are
1.Treasury bonds
- Semi-government bonds (semis)
- Corporate bonds
- Mortgage-backed bonds
Bonds
A bondis a long-term debt security which pays periodic interest over the life of the security
Par value or face value
The amount that will be repaid when the bond matures
Coupon rate
The rate of interest paid periodically
Price
The current value of the bond
Yield
The current level of interest rates
Maturity date
The date the bond matures
Treasury bonds
These are bonds issued by the Commonwealth government to raise long-term debt funding
Semi-government bonds (semis)
Borrowing authorities issue semi-government bonds (known as semis) on behalf of state and local governments in order to raise long-term debt
Corporate bonds
Bonds issued by companies vary greatly in credit risk, from “blue chip” bonds issued by banks and our biggest companies, such as BHP and Telstra, to speculative grade (sometimes referred to as junk) bonds ADIs normally only invest in bonds issued by banks and companies with high credit ratings
Mortgage-backed bonds
Mortgage-backed securities offer as security a claim on the cash flows generated by a parcel of housing (mortgage) loans
An ADI’s priorities in deciding how to invest its funds in various types of assets normally follow a particular hierarchy, as follows:
- Satisfying legal reserve requirements
- Purchasing liquid assets to ensure adequate liquidity 3.Satisfying demand for loans
- Investing remaining funds in a securities portfoliio
SECURITIES PORTFOLIO PRIORITIES
- Managing interest rate risk
- Liquidity management
- Revenue production
- Credit risk management
- Total return including capital gain
As well as maturity limits, attention should be given to the scheduling of maturities The three main approaches used are:
The cyclical approach
The laddered approach
The barbell approach
The cyclical approach
The cyclical approach –shortening or lengthening maturities to take advantage of changing interest rates over the business cycle
The laddered approach
The laddered approach –staggering maturities up to the limit of maturity
The barbell approach
The barbell approach –a combination of short-term liquid and long-term high-yielding securities
The two main types of strategies used to adjust the maturity of the securities in a portfolio are:
Trading strategies,
Switching strategies,
Trading strategies
Trading strategies, which require constant monitoring of security prices and frequent buying and selling to try to take advantage of changing prices
Switching strategies
Switching strategies, which involve periodically changing the overall composition of the portfolio in response to changing economic conditions and interest rate
An ADI needs to develop a formal, written policy regarding the construction and management of its securities portfolio
The five basic steps in designing such a policy are:
- Establish objectives
- Inventory the ADI’s securities needs
- Comply with regulatory rules
- Establish strategies
- Delegate authority but maintain control
ExplainwhyanADImayneedtouseitssecurityportfolioasa‘balancingfactor’.What otherobjectivesmayanADIpursueinmanagingthesecurityportfolio?
AnADIwillnormallyhaveasetofassetpriorities:firsttosatisfyanylegalreserverequirements, secondtoprovideforliquidityneeds,thirdtoservetheloandemandsoftheirmarkets,and finallytheremainingfundsareinvestedinthesecurityportfolio.
Otherobjectivesofthesecurityportfolioincludegeneratingreturns,managingrisks,providing liquidity and diversifying overall exposures. Typically, there will be conflicts among these objectives;forexample,theobjectiveofgeneratingreturnswillusuallyconflictwiththeother objectives.
Outlinethemajorsourcesofriskfacingthesecuritiesportfoliomanagerofabank.
Themainrisksaremarketabilityrisk,interestraterisk,creditrisk,purchasingpowerriskand portfoliorisk
Distinguish between the laddered and cyclical approaches to maturity structures. In practice,whydoADIstypicallyusesomeformofthebarbellapproach?
Theladderedapproachinvolvesinvestingfundssothatmaturitiesareevenlyspacedover thechosentimeperiod,interestrateforecastsarenotused.Thisisalow‐riskapproach thatyieldsatleastaverageyields. Thecyclicalapproachinvolvespredictingfutureinterestrates,wheninterestratesare expectedtostoprisingandstartfallingthenmanagementshouldextendmaturitiesinthe portfolio,wheninterestratesareexpectedtostopfallingandstartrisingthenfunds shouldbereinvestedinshort‐termsecurities.Thisisahigh‐riskapproach,iftheinterest rateforecastsareincorrectthiscanhaveasubstantialadverseeffectonreturns. Thebarbellapproachinvolvesinvestingsomefundsinshort‐termsecuritiesandsome fundsinlong‐termsecurities,thisportfoliodoesnotincludemedium‐termsecurities.In general,thebarbellapproachwillyieldreturnsabovetheladderedapproachalthoughit doesalsoincurahigherlevelofrisk.Thebarbellisusuallyatradingportfoliowhere managementcanchoosetorestructuretheportfolioifitfeelsconfidentthatthisisthe appropriatestrategy,alternativelyapassiveapproachofinvestingtomaintaintheinitial ratiooflong‐termtoshort‐termsecurities,canbealmostaslowriskastheladdered approach.
AnADI’sassetsaredominatedbylong‐termloans.Explainhowthismightaffectits securitiesportfoliotransactionsiftheADIwantstolimititsinterestraterisk.
IfanADI’sassetsaredominatedbylong‐termloansthissuggeststhatithasfewrate‐sensitive assets,if,ontheotherhandthisADIhasalargeamountofrate‐sensitiveliabilitiestheitwill faceinterestraterisk–ifinterestratesrisetheADI’snetinterestincomewilltendtofallasits interestexpenseswilltendtorisebutitsinterestincomewillberelativelystatic
Thesecuritiesportfoliocanbeusedtohedgethisriskbyinvestinginshort‐term(interest sensitive)securities.Then,ifinterestratesrisethereturnonthesecuritiesportfoliowilltendto risethusoffsettingthefallingnetinterestincomeinthebankingbook.(Notethatifinterest ratesfall,thereturnonthesecuritiesportfoliowilltendtofallbutthiswillbeoffsetbya positiveeffectonthenetinterestincomefromthebankingbook.)
WhatconstraintsmightbeplacedonthesecuritiesportfoliobytheboardofasmallriskaverseADI?
Themainrisksaremarketabilityrisk,interestraterisk,creditrisk,purchasingpowerriskand portfoliorisk.Accordinglyariskaversestrategymayincluderequirementsthattheportfolio onlycomprisesecuritiesthataretradedinadeepmarket,thatarerelativelyshort‐termand thattogetherformadiversifiedportfolioofhighlyrateddomesticandforeignsecurities.
