Topic 8 - Managing Securities

Question 1

financial asset

Answer 1

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

Question 2

real asset

Answer 2

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

Question 3

security

Answer 3

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

Question 4

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

Answer 4

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

Question 5

The yieldon a security represents

Answer 5

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)

Question 6

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

Answer 6

1.Credit or default risk 

2. Liquidity or marketability risk 
3. Interest rate risk 
4. Purchasing power risk 
5. Portfolio risk

Question 7

Credit or default risk

Answer 7

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

Question 8

Liquidity or marketability risk

Answer 8

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

Question 9

Interest rate risk

Answer 9

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

Question 10

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

Answer 10

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

Question 11

Purchasing power risk

Answer 11

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

Question 12

Portfolio risk

Answer 12

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

Question 13

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

Answer 13

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

Question 14

Discount securities

Answer 14

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

Question 15

Promissory notes

Answer 15

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

Question 16

Treasury notes

Answer 16

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

Question 17

Semi-government promissory notes

Answer 17

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

Question 18

Negotiable Certificates of Deposit (NCDs)

Answer 18

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)

Question 19

Corporate promissory notes

Answer 19

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

Question 20

bill of exchange

Answer 20

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

Question 21

The three parties to a bill of exchange are:

Answer 21

DRAWER
ACCEPTOR
DISCOUNTER

Question 22

DRAWER

Answer 22

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

Question 23

ACCEPTOR

Answer 23

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

Question 24

DISCOUNTER

Answer 24

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

Question 25

When the bill matures:

Answer 25

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)

Question 26

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

Answer 26

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

Question 27

Bank-accepted bills

Answer 27

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)

Question 28

Repurchase agreements

Answer 28

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

Question 29

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

Answer 29

1.Treasury bonds  2. Semi-government bonds (semis)  3. Corporate bonds  4. Mortgage-backed bonds

Question 30

Bonds

Answer 30

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

Question 31

Par value or face value

Answer 31

The amount that will be repaid when the bond matures

Question 32

Coupon rate

Answer 32

The rate of interest paid periodically

Question 33

Price

Answer 33

The current value of the bond

Question 34

Yield

Answer 34

The current level of interest rates

Question 35

Maturity date

Answer 35

The date the bond matures

Question 36

Treasury bonds

Answer 36

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

Question 37

Semi-government bonds (semis)

Answer 37

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

Question 38

Corporate bonds

Answer 38

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

Question 39

Mortgage-backed bonds

Answer 39

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

Question 40

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

Answer 40

1. Satisfying legal reserve requirements 2. Purchasing liquid assets to ensure adequate liquidity 3.Satisfying demand for loans 4. Investing remaining funds in a securities portfoliio

Question 41

SECURITIES PORTFOLIO PRIORITIES

Answer 41

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

Question 42

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

Answer 42

The cyclical approach The laddered approach The barbell approach

Question 43

The cyclical approach

Answer 43

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

Question 44

The laddered approach

Answer 44

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

Question 45

The barbell approach

Answer 45

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

Question 46

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

Answer 46

Trading strategies, | Switching strategies,

Question 47

Trading strategies

Answer 47

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

Question 48

Switching strategies

Answer 48

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

Question 49

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:

Answer 49

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

Question 50

Explain why an ADI may need to use its security portfolio as a ‘balancing factor’. What  other objectives may an ADI pursue in managing the security portfolio?  

Answer 50

An ADI will normally have a set of asset priorities: first to satisfy any legal reserve requirements,  second to provide for liquidity needs, third to serve the loan demands of their markets, and  finally the remaining funds are invested in the security portfolio.    Other objectives of the security portfolio include generating returns, managing risks, providing  liquidity  and  diversifying  overall  exposures.  Typically,  there  will  be  conflicts  among  these  objectives; for example, the objective of generating returns will usually conflict with the other  objectives.

Question 51

Outline the major sources of risk facing the securities portfolio manager of a bank. 

Answer 51

The main risks are marketability risk, interest rate risk, credit risk, purchasing power risk and  portfolio risk

Question 52

Distinguish  between  the  laddered  and  cyclical  approaches  to  maturity  structures.  In  practice, why do ADIs typically use some form of the barbell approach? 

Answer 52

The laddered approach involves investing funds so that maturities are evenly spaced over  the chosen time period, interest rate forecasts are not used. This is a low‐risk approach  that yields at least average yields.    The cyclical approach involves predicting future interest rates, when interest rates are  expected to stop rising and start falling then management should extend maturities in the  portfolio, when interest rates are expected to stop falling and start rising then funds  should be reinvested in short‐ term securities. This is a high‐risk approach, if the interest  rate forecasts are incorrect this can have a substantial adverse effect on returns.    The barbell approach involves investing some funds in short‐term securities and some  funds in long‐term securities, this portfolio does not include medium‐term securities. In  general, the barbell approach will yield returns above the laddered approach although it  does also incur a higher level of risk. The barbell is usually a trading portfolio where  management can choose to restructure the portfolio if it feels confident that this is the  appropriate strategy, alternatively a passive approach of investing to maintain the initial  ratio of long‐term to short‐term securities, can be almost as low risk as the laddered  approach.

Question 53

An ADI’s assets are dominated by long‐term loans. Explain how this might affect its  securities portfolio transactions if the ADI wants to limit its interest rate risk. 

Answer 53

If an ADI’s assets are dominated by long‐term loans this suggests that it has few rate‐sensitive  assets, if, on the other hand this ADI has a large amount of rate‐sensitive liabilities the it will  face interest rate risk – if interest rates rise the ADI’s net interest income will tend to fall as its  interest expenses will tend to rise but its interest income will be relatively static The securities portfolio can be used to hedge this risk by investing in short‐term (interest  sensitive) securities. Then, if interest rates rise the return on the securities portfolio will tend to  rise thus offsetting the falling net interest income in the banking book. (Note that if interest  rates fall, the return on the securities portfolio will tend to fall but this will be offset by a  positive effect on the net interest income from the banking book.) 

Question 54

What constraints might be placed on the securities portfolio by the board of a small riskaverse ADI?  

Answer 54

The main risks are marketability risk, interest rate risk, credit risk, purchasing power risk and  portfolio risk. Accordingly a risk averse strategy may include requirements that the portfolio  only comprise securities that are traded in a deep market, that are relatively short‐term and  that together form a diversified portfolio of highly rated domestic and foreign securities.