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Banking and Financial Institutions > Topic 8 - Managing Securities > Flashcards

Topic 8 - Managing Securities Flashcards

1
Q

financial asset

A

A financial asset is an intangible claim or right to receive future cash flows

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2
Q

real asset

A

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

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3
Q

security

A

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

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4
Q

a security has certain distinguishing features, compared to financial assets that are not securities:

A

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

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5
Q

The yieldon a security represents

A

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)

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6
Q

The main types of risk that an ADI needs to take into account when constructing its securities portfolio are:

A

1.Credit or default risk 

  1. Liquidity or marketability risk 
  2. Interest rate risk 
  3. Purchasing power risk 
  4. Portfolio risk
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7
Q

Credit or default risk

A

This is the risk that the issuer of a security will not pay interest or repay the principal on maturity

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8
Q

Liquidity or marketability risk

A

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

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9
Q

Interest rate risk

A

This refers to the variability in returns as a result of changes in the general level of interest rates

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10
Q

There are two components of interest rate risk, which affect overall returns in opposite ways:

A

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

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11
Q

Purchasing power risk

A

This is variability in the purchasing power of those future cash flows due to changes in the rate of inflation

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12
Q

Portfolio risk

A

This refers to the risk of a diversified portfolio of securities, rather than individual securities

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13
Q

The main examples of Short Term Securities in an ADI’s portfolio are:

A
  1. Treasury notes 
  2. Semi-government promissory notes 
  3. Negotiable Certificates of Deposit (NCDs) 
  4. Corporate promissory notes (commercial paper) 
  5. Bank-accepted bills 
  6. Repurchase agreements
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14
Q

Discount securities

A

Almost all short-term securities are discount securities, which means that they don’t make interest payments over the life of the security

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15
Q

Promissory notes

A

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

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16
Q

Treasury notes

A

These are promissory notes (discount securities) issued by the Commonwealth government to meet its short-term funding requirements

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17
Q

Semi-government promissory notes

A

These are similar to treasury notes, but are issued by state and local governments to raise short-term funding

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18
Q

Negotiable Certificates of Deposit (NCDs)

A

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)

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19
Q

Corporate promissory notes

A

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

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20
Q

bill of exchange

A

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

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21
Q

The three parties to a bill of exchange are:

A

DRAWER
ACCEPTOR
DISCOUNTER

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22
Q

DRAWER

A

Thisisanothernameforthe borrower.Thedrawer“draws up”aninstructiontothe acceptortopaytheholderof thebillasumofmoney(the facevalue)on aparticulardate inthefuture.

23
Q

ACCEPTOR

A

Theacceptor“accepts”the instruction(inreturnforan acceptancefee,whichispart oftheborrower’scostof borrowing).Thisturnsthebill intoamarketablesecurity.

24
Q

DISCOUNTER

A

Thedrawercanthenborrow bysellingthesecuritytoa discounter–another namefor thelender.Thediscounter paysadiscountedamount(less thanthefacevalue)toreflect thetimevalueofmoney.

25
Q

When the bill matures:

A

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)

26
Q

If the bill is sold by the discounter into the secondary market prior to maturity:

A

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

27
Q

Bank-accepted bills

A

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)

28
Q

Repurchase agreements

A

Under a repurchase agreement, an asset is sold subject to an agreement that the seller will repurchasethe asset in the future

29
Q

The main examples of long-term securities in the securities portfolio or an ADI are

A

1.Treasury bonds 

  1. Semi-government bonds (semis) 
  2. Corporate bonds 
  3. Mortgage-backed bonds
30
Q

Bonds

A

A bondis a long-term debt security which pays periodic interest over the life of the security

31
Q

Par value or face value

A

The amount that will be repaid when the bond matures

32
Q

Coupon rate

A

The rate of interest paid periodically

33
Q

Price

A

The current value of the bond

34
Q

Yield

A

The current level of interest rates

35
Q

Maturity date

A

The date the bond matures

36
Q

Treasury bonds

A

These are bonds issued by the Commonwealth government to raise long-term debt funding

37
Q

Semi-government bonds (semis)

A

Borrowing authorities issue semi-government bonds (known as semis) on behalf of state and local governments in order to raise long-term debt

38
Q

Corporate bonds

A

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

39
Q

Mortgage-backed bonds

A

Mortgage-backed securities offer as security a claim on the cash flows generated by a parcel of housing (mortgage) loans

40
Q

An ADI’s priorities in deciding how to invest its funds in various types of assets normally follow a particular hierarchy, as follows:

A
  1. Satisfying legal reserve requirements
  2. Purchasing liquid assets to ensure adequate liquidity 3.Satisfying demand for loans
  3. Investing remaining funds in a securities portfoliio
41
Q

SECURITIES PORTFOLIO PRIORITIES

A
  1. Managing interest rate risk
  2. Liquidity management
  3. Revenue production
  4. Credit risk management
  5. Total return including capital gain
42
Q

As well as maturity limits, attention should be given to the scheduling of maturities The three main approaches used are:

A

The cyclical approach
The laddered approach
The barbell approach

43
Q

The cyclical approach

A

The cyclical approach –shortening or lengthening maturities to take advantage of changing interest rates over the business cycle

44
Q

The laddered approach

A

The laddered approach –staggering maturities up to the limit of maturity

45
Q

The barbell approach

A

The barbell approach –a combination of short-term liquid and long-term high-yielding securities

46
Q

The two main types of strategies used to adjust the maturity of the securities in a portfolio are:

A

Trading strategies,

Switching strategies,

47
Q

Trading strategies

A

Trading strategies, which require constant monitoring of security prices and frequent buying and selling to try to take advantage of changing prices

48
Q

Switching strategies

A

Switching strategies, which involve periodically changing the overall composition of the portfolio in response to changing economic conditions and interest rate

49
Q

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:

A
  1. Establish objectives
  2. Inventory the ADI’s securities needs 
  3. Comply with regulatory rules 
  4. Establish strategies 
  5. Delegate authority but maintain control
50
Q

ExplainwhyanADImayneedtouseitssecurityportfolioasa‘balancingfactor’.What otherobjectivesmayanADIpursueinmanagingthesecurityportfolio?

A

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.

51
Q

Outlinethemajorsourcesofriskfacingthesecuritiesportfoliomanagerofabank.

A

Themainrisksaremarketabilityrisk,interestraterisk,creditrisk,purchasingpowerriskand portfoliorisk

52
Q

Distinguish between the laddered and cyclical approaches to maturity structures. In practice,whydoADIstypicallyusesomeformofthebarbellapproach?

A

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.

53
Q

AnADI’sassetsaredominatedbylong‐termloans.Explainhowthismightaffectits securitiesportfoliotransactionsiftheADIwantstolimititsinterestraterisk.

A

IfanADI’sassetsaredominatedbylong‐termloansthissuggeststhatithasfewrate‐sensitive assets,if,ontheotherhandthisADIhasalargeamountofrate‐sensitiveliabilitiestheitwill faceinterestraterisk–ifinterestratesrisetheADI’snetinterestincomewilltendtofallasits interestexpenseswilltendtorisebutitsinterestincomewillberelativelystatic
Thesecuritiesportfoliocanbeusedtohedgethisriskbyinvestinginshort‐term(interest sensitive)securities.Then,ifinterestratesrisethereturnonthesecuritiesportfoliowilltendto risethusoffsettingthefallingnetinterestincomeinthebankingbook.(Notethatifinterest ratesfall,thereturnonthesecuritiesportfoliowilltendtofallbutthiswillbeoffsetbya positiveeffectonthenetinterestincomefromthebankingbook.)

54
Q

WhatconstraintsmightbeplacedonthesecuritiesportfoliobytheboardofasmallriskaverseADI?

A

Themainrisksaremarketabilityrisk,interestraterisk,creditrisk,purchasingpowerriskand portfoliorisk.Accordinglyariskaversestrategymayincluderequirementsthattheportfolio onlycomprisesecuritiesthataretradedinadeepmarket,thatarerelativelyshort‐termand thattogetherformadiversifiedportfolioofhighlyrateddomesticandforeignsecurities.

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