Bank Management and Commercial Lending
From Chapter 16 – Managing the Investment Portfolio
Chapter 16 is huge, and there is no way we could cover all of its material. Nonetheless, a few key
ideas stand out. Those “ideas” are highlighted below, and in the next couple of pages.
First, recall the bank performs three primary functions wrt its investment “trading” activities:
1. It provides investment advice
2. Provides and inventory of securities
3. It engages in speculative trading, this third activity much-curtailed following the
credit crisis and the passage of Dodd-Frank, the financial services bill passed by the
congress following the financial crisis.
Second, the objectives of the investment portfolio, for the bank, are:
1. Liquidity
2. Yield
3. Diversify risk
4. Safety
5. Manage interest rate exposure
6. Meet pledging (repo) requirements
Third, banks classify securities into three categories:
1. Trading – carried at market value on the balance sheet. Unrealized gains and losses
are included as income with trading securities.
2. Hold-to-maturity – held at amortized cost (like mortgages)
3. Available for sale – carried at market value on the balance sheet. Unrealized gains
and losses on these are included as a component of capital.
4. Banks are generally prohibited from owning straight stock.
Keep in mind that all of this exists in the context of the financial crisis; banks are more cautious
and constrained than before 2008.
The funding flows for banks are fascinating. The investment portfolio is at the center of these
flows. For example, treasury bills are often used as collateral for overnight loans – these loans
are called REPO’s by the bank putting up the bills, and REVERSE REPO’s by the banks putting
up the loan money. Every REPO involves a regular repo and a reverse repo. These transactions
can vary from a day to a year. (Your text allows that REPO rates are between 15 and 50 basis
points (BP’s) below the fed funds rate, but in a world of .25% FFR’s, this makes little sense.
Recall anything with a maturity of less than one year is known as a money market instrument,
and with maturities greater than one year as a capital market instrument.
A number of new investments and investment uses have evolved over the past couple decades –
1. Repos (p. 707 of your text) Discussed above.
2. T-Bills (p. 709, as overnight collateral, etc) These are bought and sold at a discount, with
the annualized rate being calculated using a 360 day year.
Discount Rate = (10,000 – current price)/10,000 x (360/days to maturity)
[See example in class]
3. Commercial paper (p. 711) – typically unsecured notes from corporations, traded on
loosely organized exchanges. This is the market that locked up in late 2008, signaling a
grave potential unraveling of the world money markets. In general, CP has a maturity of
less than 270 days.
4. CD’s of other banks, Eurodollars – dollars on deposit in foreign banks. (Yankee bonds –
instruments issued by foreign banks in dollars, with interest and maturity paid in dollars).
Yankee bonds and ED’s are popular as foreign markets are less regulated than US
markets. Bankers acceptances (p. 712) are short term interest-bearing tie drafts created by
good banks and often used in international trade. Because the likelihood of default is low,
these are often treated almost like currency in international trade.
5. T-notes and bonds (p. 712) These pay interest semi-annually, and their valuation is
handled just like the valuation of a corporate bond in FIN 335 or FIN 336, except the
maturity value of these is $10,000, not $1,000. Prices are quoted in 32nd’s, though a
recent perusal of some T-bond quotes suggests that both the bid and the ask prices for
these bonds are quoted in partial 32nds, as well. Recall the example in class, where we
found that a bond maturing in 4 years (8 semi-annual coupon payments), selling for
$9,900 with a 2% coupon ($100 payments) is selling at a YTM or Ask Yield of 2.28%.
(See below)
Maturity
Coupon
Bid
Ask
Change
AskYl
11/15/2012
1.375
n.a.
n.a.
n.a.
n.a.
11/15/2012
4.000
100.0078
100.0156
-0.0078
-1.708
11/30/2012
0.500
100.0156
100.0234
0.0000
-0.036
11/30/2012
3.375
100.1406
100.1484
-0.0078
-0.020
12/15/2012
1.125
100.0781
100.0859
0.0039
0.110
12/31/2012
0.625
100.0547
100.0625
0.0000
0.135
12/31/2012
3.625
100.4375
100.4453
-0.0078
0.136
Maturity
Coupon
Bid
Asked
Chg
Asked
yield
11/15/2013
0.500
100.0000
100.0078
-0.0078
-0.457
11/15/2013
4.250
100.0313
100.0391
-0.0469
-0.530
11/30/2013
0.250
100.0078
100.0156
0.0000
-0.068
11/30/2013
2.000
100.0938
100.1016
-0.0156
-0.064
12/15/2013
0.750
100.0508
100.0742
-0.0117
-0.073
12/31/2013
0.125
100.0000
100.0156
unch.
0.008
6. Agency debt (Fannie, Freddie, and Ginnie) Ginnie is formally part of the government,
prior to 2008, but Fannie and Freddie are effectively now federal wards, as well. We
discussed Fannie strips, sold as ZERO’s, in class.
7. Conventional MBS’s – these are simply any instrument representing an undivided interest
in a mortgage loan. These MBS’a are in addition to the ones issued by Fannie, Freddie
and Ginnie.
Remember the implied puts and calls (options) that attach to most mortgage
loans.
Imagine the value of these “options.” The call option? The right to prepay. The put option? The
right to “walk away” and “put” the collateral to the lender. From the lender’s perspective,
prepayment risk (exercise of the call option) is greater with higher interest, longer term
mortgages. (Ignore Exhibit 16.5 in your text). If the borrower declines the call option, he or she
typically gets a lower up front rate, AND the loan is typically assumable, uncommon with other
mortgages (sort of makes sense – if you are locked out of prepaying, and resell the property, the
lender MUST allow for the loan to be assumed by the new buyer). Warehouse example from
FL.
Collateralized Mortgage Obligations (CMO’s) were birthed in 1983 to circumvent prepayment
risk. That risk is “priced” into the mortgages with the trading of the underlying securities.
Mortgage pools are combined as security for bonds with varying maturities. “New” refinanced
mortgages remain as collateral, and with the prepayment risk removed, interest rates on the
CMO’s are lower!
Asset-backed securities (p. 727) are similar to MBS’s and CMO’s: CAR’s (collateralized
automobile receivables) and CARD’s (certificates for amortizing revolving debt) are ABS’s on
car loans and credit cards.
Similar traded securities - Sallie Mae or SLM Corp [sired from the original Student Loan
Marketing Association] ABS’s - exist that are backed by student loans. The Sallie Mae GSE was
created by congress in 1972 to facilitate the flow of funds to education. Recent data suggest that
the total loans under Sallie Mae’s umbrella total over $200 billion. (not in the text)
CDO’s are collateralized debt obligations founded on various other bank loans (construction
loans, AR factors, etc). CDO’s got crushed in 2008, but that market is beginning to come back to
life.
Municipal bonds (MUNI’s) are the final security we examine, with which investments are made
by many contemporary banks. Recall the tax-sheltered status of MUNI’s, at the federal level.
Local and state income taxes (they have local income taxes in a number of communities “up
north.”) are often avoided, as well, with the purchase of MUNI’s from those taxing states and
communities. Recall the indifference point for investors in MUNI’s or taxable bonds:
With ATCF = after-tax cash flow, and BTCF = before-tax cash flow
Indifference Point is where ATCFcorporate bond = ATCFMUNI
And, the ATCF of a corporate = BTCF (1- Tax Rate)
The ATCF of a MUNI, ignoring state and local taxes = BTCF of a MUNI
Look over the MUNI example from class.
From around p. 731, there are three general types of MUNI’s.
1. General obligation bonds – for schools, courthouses, etc
2. Revenue bonds – toll bridges, convention centers, etc
3. Industrial development bonds (less favored these days) – new factories. Discuss. The Tax
Reform Act of 1986 greatly curtailed the use of IRB’s.
In Chapter 16, focus on the assigned questions and problems, and pages 697-731. On p. 745,
embedded option values (as with calls and puts in a mortgage) are considered. Understand the
STORY with those: leave the mechanics to your employer after college, or save them for
graduate school, if you go to a really GOOD graduate school! (don’t worry about pp. 732-738)
Managing the investment portfolio for the bank involves a great deal of detail, and the portfolio’s
exposure to different market, economic and interest rate risk deserves continuing analysis.
Contra-cyclical investing is one strategy; riding the yield curve is another.
Ladder strategies simply have the bank investing equally in each step of the ladder, in each year
up to a 20 or 30 year horizon. Maturing bonds provide liquidity.
Barbell strategies, on the other hand, involve holding some minimum of the bond portfolio very
short term for liquidity purposes, and investing the balance much longer term to achieve the
higher interest rates of longer maturities. This assumes, of course, an upwardly sloping yield
curve! (Discuss)
With contra-cyclical investing, the banks “bet” on the direction of the economy by lending long,
and large, when interest rates are high, and lending short when they are low. (This seeks to
capture greater loan demand near the peak of a business cycle, when rates are high, and before
rates fall). The risk, of course, is that loan activity will be greater just as loans begin to default –
the text does not highlight this!
By riding the yield curve (p. 740), the firm simply hopes for stable interest rates, and invests
longer than liquidity needs might suggest (“we need $1 million in five years, let’s buy a 10-year
bond and pocket the extra interest rate we earn over what would have been a five-year
investment.”). This is a common practice for many banks, and is a practice that helped to sink the
thrift industry in the 1980’s – your text also does not mention this! Back then, S and L’s bought
long (lending on long term mortgages) and borrowed short (with CD’s and savings deposits) and
as rates skyrocketed, they were stuck with fixed rate long term mortgages on the LHS of the BS,
and short term increasingly costly stuff on the RHS of the BS. Bummer.
And, as the bond investments are accumulated, duration and convexity measure the riskiness of
those investments.
Basically, DURATION = (∆Price/Price)/∆YTM/(1+YTM) = (∆P/P)/∆i/(1+i)
Try this with a short and a long bond, with changing interest rates. You find the longer term bond
has the higher duration. (See duration example below).
Duration (p. 751) is a measure of the sensitivity of a bond, or an entire portfolio of interestbearing investments, to changes in interest rates.
Duration = [(ΔBond Price/Bond Price)/( ΔYTM/(1+ YTM))],
Or for the entire portfolio, it would be the change in the portfolio value relative to changes in the
markets yields to maturity. In words, the longer we wait for a fixed set of future cash flows, as
from a bond, the greater our duration.
An example:
Bond A, matures in 5 years, 5% coupon, current market rates of 5% rise to 6%. Its duration?
Original price was $1000, trading at face value with a 5% YTM. New price with a 6% YTM is
$958 (1000 FV, 50 PMT, 5 N, 6 I/Y, CPT PV = -957.88)
Duration = [(42/1000)/(.01/1.05)] = .042/.0095= 4.42 years
If it were a 10 year bond in this environment? (CPT PV = - 926.40 or so)
Duration = [(74/1000)/(.01/1.05)] = 7.79 years
Duration is greater the longer to maturity, and it is greater the smaller the coupon (or if it is a
zero coupon bond, the duration is longer than for a bond with a coupon.)
A 5-year zero coupon bond with rates moving from 5 to 6%?
Duration = [(36.27/783.53)/(.01/1.05)] = 4.87 or about 5 years (the duration of a zero is pretty
much equal to its time to maturity).
Or, if you like, get the notes from FIN 430, as duration is covered in there, as well.
What are the implications of duration for the investor? Betting on interest rate changes, we ramp
up the risk (on the upside and downside) with greater duration.
Convexity is the second derivative of the change in the bond’s price relative to changes in interest
rates. Convexity is a measure of the change in the rate of change in bond prices relative to
changing interest rates….convexity answers the question: How is the rate of change in bond
prices relative to interest rates changing as rates go up or down?
We excuse you from the pure quantitative mechanics of convexity in FIN 437 and FIN 438. We
likely do NOT excuse you from those mechanics for duration!
Duration gets bigger the longer you wait for the big cash flows; duration is larger for zeros and
long term low-interest bonds. Duration is smaller for near-term or high-coupon bonds.
Use these notes, and the notes from class, and worry not about pages 750-755. MUNI work on
pages 755-761? Covered above, and in FIN 335. You are not responsible for pages 761-766 (or
732-738, as mentioned above).
And, of course, the assigned questions, with solutions on the web site, are a dandy source of
understanding and insight.
Chapter 16: Bank Management: A few practice problems and some
selected answers to assigned end of chapter questions
1. Unlike a retail - and many other institutional - investors, the bank often sells at the “ask” and
buys at the “bid.” Recall the bid/ask spread - in all trades of stocks or bonds or commodities
or foreign currencies or derivative – assures the dealer a “profit” independent of the
dealer’s actual buying and selling of securities for its own account. The retail investor buys
at the ask, and sells at the bid. This is why a dealer’s ask price exceeds the bid price at any
point in time. A bank also makes a profit when it sells securities, typically from its
proprietary trading accounts, for a higher price than it pays for the securities. It is these
trading accounts that are drawing regulatory scrutiny as the financial crisis unfolds, and
(hopefully) is resolved.
2. As banks are not uniformly required to report losses automatically on securities they hold
whose market values are less than book, they hesitate in selling these securities and taking a
loss; losses lower reported net income returns to shareholders. Stockholders and investors
may not understand the benefits or ramifications of this type of loss. Not selling discounted
securities, or any securities, helps stabilize interest income. The cost of continuing to hold
discounted securities, however, is foregone interest income from reinvesting proceeds as
well as the likelihood that securities falling in value will continue their descent.
3. Zero coupon securities pay no coupon interest and have longer durations than comparable
maturity securities that pay regular interest. Zero coupon Fannie Mae “strips” come to
mind; there, as the investor waits until maturity for the one and only cash flow from the
security, the investor is subject to much greater interest-rate sensitivity. It is common sense.
With a “normal” bond maturing in a year or two, with continuing interest payments until
maturity, one would expect a graver price change with a ZERO than with a bond generating
cash flows up until maturity. Do the math. The percent change of the normal bond is less
with an overall change in market rates than the change with a ZERO. Zeroes are less liquid,
holding other factors constant.
4. Banks may not invest in non-investment grade debt securities, those originally nonrated or
rated below Baa, unless they can demonstrate that the effective rating is at least Baa
equivalent (for nonrated securities). Banks cannot generally buy and sell common stock
directly for investment purposes. Certain banks may purchase common stock indirectly via
qualifying mutual funds. If common stock is held as collateral on a bank loan, and the loan
goes into default, the bank is often required to immediately liquidate the stock if it is
“repossessed” by the bank in a default proceeding.
5. Small banks hold more securities in percentage terms than do large banks, and concentrate
their holdings more in Treasury securities and municipal securities. Mutual funds may be
attractive because they provide a more efficient route to diversification; rather than buying
imperfectly correlated securities one at a time to provide the benefits of diversification, the
mutual fund accomplishes that task for the investor. This is a more attractive option for the
smaller bank that is less able to spread its portfolio across a multitude of assets – reducing
risk – than the larger bank.
6. Time trends: 1) declining holdings of Treasury securities, 2) increasing holdings of agency
securities, which includes most mortgage-backed securities, 3) declining holdings of
municipals, and 4) increasing holdings of corporate and foreign securities. The driving
forces behind these trends include the general low return on Treasuries, banks seeking
higher yields on mortgage-backed securities and agencies, and the fact that the Tax Reform
Act of 1986 made many municipals unattractive (low yielding) for banks. This pattern
contributed to the defaults of many banks after 2008 and the publication of the text.
“Agency securities” are comprised largely of Fannie Maes and Freddie Macs, which MBS’s
have defaulted, in droves. Federal government backing of the securities, and bailouts of the
two GSE’s approaching $200 billion by the end of 2011, are the result.
In terms of bank size, smaller banks invest proportionately more in securities at around 24%
of assets, while the 10 largest banks invested almost 21% of assets in securities. However,
without trading account securities, these 10 largest banks invested just 15% of assets in
securities. Agencies and corporate bonds are the dominant security class at all size banks.
7. A callable bond gives the issuer the right to call the bond, or pay the principal back prior to
maturity, after the call deferment period has expired. The longer the call deferment period,
the greater is the protection to the buyer of the callable bond because the issuer must wait
longer to exercise the option. Thus, a buyer of a callable bond will receive a lower promised
yield, ceteris paribus, when the call deferment period is long. The primary advantage of a
discount callable bond is that there is some room for price appreciation; the call price will be
higher than the discount price, and if the bond is called (generally at par or a higher price)
that difference will be an additional gain for the investor. Generally, callable bonds can be
called at par or a higher price. If rates fall sufficiently, the bonds will be called; this occurred
with almost all Fannie Mae and Freddie Mac strips in the late 1990’s and early 2000’s, as
those strips were drawn from mortgage pools containing mortgages issued at much higher
interest rates that existed in the 1990’s vs the early 2000’s. As the mortgages underlying the
strips (or zero coupon agency bonds) were refinanced and prepaid, the strips attaching to
them were called.
8. Objectives:
1) Safety and preservation of capital: low credit risk in securities
2) Liquidity: most securities owned by banks can be readily sold in well-established
secondary markets; thus, securities can be used to meet liquidity needs
3) Yield: securities provide income in the form of coupon interest, reinvestment income,
and capital gains
4) Credit risk diversification: for monies loaned. Loans incorporate considerable credit risk;
banks that limit securities holdings to investment grade instruments largely limit credit
risk
5) Managing interest rate risk: for securities bought in the primary and secondary
markets. This “management” is used to adjust a bank’s GAP/duration gap and earnings
sensitivity or MVE sensitivity profile easily and quickly without harming any customer
relationship
6) Pledging requirements: banks must post collateral against certain liabilities, such as
public deposits, borrowing from the Federal Home Loan Bank and Federal Reserve, and
Repos. Securities are the best form of collateral.
9. A reverse repo is effectively a collateralized federal funds sold transaction. The borrower
with a reverse repo actually puts up the collateral up front. A federal funds loan is not
directly secured, but the undelivered collateral is typically observable. Because of the
collateral, the reverse repo carries a lower yield, and a lower cost to the “borrowing” bank.
11.
Prepayment risk
a. When mortgage rates fall, prepayments on high-coupon MBSs will increase relative to
prepayments on low-coupon MBSs because the rate differential and refinancing
advantage will be greater for the high-coupon mortgages. When mortgage rates rise,
prepayments will slow. If prepayments slow sufficiently, the investor will receive
increased interest payments on the high-coupon IO for a longer period of time, such
that the 10's price might rise.
b. Prepayments generally increase over time the longer the underlying mortgages are
outstanding, up to a point. Generally, newly issued mortgages don’t prepay quickly
because the property buyer is just getting settled into the property and there is less
likelihood that the current mortgage rate is well below the mortgage rate on the new
mortgage. Thus, 6-year old mortgages generally prepay at higher speeds.
c. Prepayments are typically higher in markets that are booming with high growth as
employees move frequently. In addition, the age of the population and income help
determine prepayments as younger and wealthier workers and families move more
frequently.
12.
The term ‘tranche’ refers to a class of securities. First tranche securities in a CMO have
the lowest prepayment risk of any tranche because principal is first allocated there to repay
security holders. Last tranche security investors (as with many interest-only MBS’s) are paid only
after all other investors, so there is considerable uncertainty as to when the principal payments
will be made. To compensate for this greater uncertainty, the higher risk (last tranche) CMO will
carry a higher promised yield.
14.
Mortgage-backed securities are often stripped into IO (interest-only) and one PO
(principal only) strips. The PO represents a stream of partial principal payments for each month
the mortgage is outstanding. The mortgage-backed I0 differs represents the interest portion of
each monthly mortgage payment.
18.
With a contracyclical investment strategy, banks will generally buy longer-duration
securities when interest rates are relatively high. This means buying long-term instruments
when the yield curve inverts. Experiences from the early 1980’s bear recalling; there, the longest
term rates (of 10 years or more) were in the 14-16 percent range, and shorter term rates (one
year or less) were close to 20%. Banks that “went long” in that period were amply rewarded.
Many banks follow this strategy and have systematically earned more than competitors who did
not. Buyers of long term bonds in the early 1980’s, when short term rates approached 20%, but
long term rates never went much higher than the mid-teens. The long-term bond buyer in 1981
was rewarded by the mid 1980’s as interest rate fell, and those high-yielding bond prices
skyrocketed (or the bonds were called at prices much higher than the ones at which the bonds
were purchased).
20.
For: improve returns if banks can time the business cycle and future rate movements.
Against: speculation involves increasing risk, and managers cannot systematically forecast
interest rates better than the market.
An efficient markets proponent generally believes that an investor cannot outperform the
market from publicly available information. As such, timing purchases of securities relative
to the business cycle and other indices is speculative as forward rates should reflect
consensus expectations about future rates. These forward rates should be unbiased
forecasts.
22.
Riding the yield curve is based on the theory that long-term securities carry a maturity
premium. Investors buy securities with maturities longer than their holding period and expect to
sell them at a gain (because rates will not rise above forward rates) as time elapses and rates on
shorter-term securities are below the coupon rate of the bond owned. An investor can ride the
yield curve even when it’s inverted if long-term rates carry the premium and the holding period
is sufficiently long. In terms of total return, the investor will earn greater coupon interest,
reinvestment income will be higher, and the security can be sold at a gain.
25.
Sale of the bond produces $5.23 million - .34($0.23 million) = $5,151,800
Note that this bond pays an 8% coupon rate
Investment income at 6.6% annually (3.3% semiannually):
.033 ( $5,151,800) = $170,009.40 for six semiannual periods
Lost periodic interest $200,000 - $170,009.40 = $29,990.60 for three years.
Differential income in the last (fourth) year will depend on what the bank would do with
the proceeds and prevailing rates at that time.
26.
Sale of bond produces $960,000 + .34($40,000) = $973,600
Note that this bond pays a 5.8% coupon rate
Investment income at 6.2% annually (3.1% semiannually):
.031 ($973,600) = $30,181.60 for four semiannual periods
Higher periodic interest = $30,181.60 - $29,000 = $1,181.60.
27.
After-tax yields
a. Taxable corporate yields 0.0710(1-.28) = 0.05112; municipal yields 0.059. The
municipal yields more after tax.
b. Taxable corporate yields 0.0710(1-.29-.09) = 0.0447; municipal yields 0.059. The
municipal yields more after tax.
Chapter 16 Sample Questions: Managing the Investment Portfolio
1. Regulators generally prohibit banks from purchasing ____________ for income purposes.
a. Treasury bills
b. commercial paper
c. common stock
d. repurchase agreements
e. bankers' acceptances
2. Which of the following classes of securities are recorded at amortized cost on the balance sheet?
a. Held-to-maturity
b. Available-for-sale
c. Trading
d. all of the above
e. a. and b. only
3. Which of the following classes of securities are carried at market value on the balance sheet?
a. Held-to-maturity
b. Available-for-sale
c. Trading
d. all of the above
e. b. and c. only
4. For which of the following classes of securities are unrealized gains and losses included as a
component of capital?
a. Held-to-maturity
b. Available-for-sale
c. Trading
d. all of the above
e. a. and c. only
5. For which of the following classes of securities are unrealized gains and losses included as income?
a. Held-to-maturity
b. Available-for-sale
c. Trading
d. all of the above
e. b. and c. only
6. All of the following are basic functions of a bank's trading activities except:
a. offering investment advice to customers.
b. maintaining an inventory of securities for possible sale to investors.
c. speculating on short-term interest rate movements.
d. All of the above are basic functions of a bank's trading activities.
e. None of the above are basic functions of a bank's trading activities.
7. Which of the following is not an objective of a bank's investment portfolio?
a. Meeting capital requirements
b. Maintaining liquidity
c. Diversifying credit risk
d. Managing interest rate exposure
e. Preserving capital
8. Most repurchase agreements are secured by:
a. municipal securities.
b. commercial paper.
c. Treasury securities.
d. discount window loans.
e. cash.
9.
a.
b.
c.
d.
e.
Which of the following is true of Treasury bills?
Interest on Treasury bills is exempt from state income taxes.
Treasury bills are sold at a discount.
Treasury bills pay a lower pretax yield than comparable corporate securities.
All of the above are true.
a. and c. only
10. A bank purchases a new 52-week $1,000,000 face value Treasury bill for $950,000. What is the
discount rate on this T-bill (Hint: A 52-week T-bill has an original maturity of 364 days)
a. 4.95%
b. 5.00%
c. 5.06%
d. 5.19%
e. 5.26%
Answer: a
dr = [(FV – P)/FV]*(360/n) = [($1,000,000 – $950,000)/$1,000,000]*(360/364) = .0495
11. Eurodollar:
a. deposits are dollar-denominated deposits issued outside the United States.
b. markets are less regulated than U.S. security markets.
c. rates generally are lower than comparable U.S. CD rates.
d. all of the above
e. a. and b. only
12. Dollar-denominated deposits issued by branches of foreign banks in the United States are known as:
a. Asian bonds.
b. Eurodollar bonds.
c. Foreign bonds.
d. Yankee bonds.
e. Domestic bonds.
13. In general, commercial paper:
a. is more liquid than a treasury bill.
b. has a maturity of 270 days or less.
c. sells at a premium to face value.
d. all of the above
e. a. and b. only
14. A short-term interest-bearing time draft created by a high-quality bank is called:
a. commercial paper.
b. a bankers acceptance.
c. a Eurodollar deposit.
d. a reverse repurchase agreement.
e. a negotiable CD.
15. All of the following are money market instruments except:
a. Treasury bills.
b. Eurodollar deposits.
c. commercial paper.
d. Treasury bonds.
e. bankers acceptances.
16. All of the following are capital market instruments except:
a. Treasury bonds.
b. Government National Mortgage Association (Ginnie Mae) bonds.
c. mortgage backed securities.
d. Commercial paper
e. CMO’s
17. Prior to the financial crisis, which of the following U.S. government agency securities were backed
by the “full faith and credit of the U.S. Government?”
a. Government National Mortgage Association (Ginnie Mae)
b. Student Loan Marketing Association (Sallie Mae)
c. Conventional mortgages
d. all of the above
e. a. and c. only
18. Prior to the financial crisis, which government sponsored enterprise (GSE) securities had only the
implied backing of the US Government?
a. Farm Credit System
b. Federal Home Loan Banks
c. Government National Mortgage Association (Ginnie Mae)
d. Federal National Mortgage Association (Fannie Mae)
e. Student Loan Marketing Association (Sallie Mae)
19. The underlying mortgages in Ginnie Mae mortgage pools include:
a. Federal Housing Association (FHA) mortgages.
b. Fannie Mae mortgages.
c. privately issued mortgages.
d. all of the above
e. a. and b. only
20. Mortgage prepayment risk:
a. is greatest for stripped securities.
b. increases as interest rates increase.
c. is eliminated in Z-tranche CMOs.
d. is eliminated by buying stripped mortgage backed securities that mature when the bank needs the
funds.
e. is larger on high-rate mortgages.
21. Municipal bonds whose primary source of repayment are the revenues from the underlying financed
project are known as:
a. general obligation bonds.
b. credit free bonds.
c. revenue bonds.
d. exempt bonds.
e. liquidity bonds.
f.
22. Which of the following bonds will likely have the greatest duration?
a. A 2-year zero-coupon bond in a period of low rates
b. A 2-year zero-coupon bond in a period of high rates
c. A 10-year low-coupon bond in a period of high rates
d. A 10-year high-coupon bond in any interest rate environment
e. A 5-year low-coupon bond in any interest rate environment
23. Municipal bonds issued for broad city or county needs, such as for new elementary schools, are
called:
a. General obligation bonds
b. Education endowment bonds
c. Department of Education mandated bonds
d. Pre-secondary education bonds
e. No-child-left-behind compliance bonds
24. Riding the yield curve:
a. is risk-free.
b. generally involves buying securities with a longer maturity than the intended holding
period.
c. can only be accomplished with stripped Treasury securities.
d. all of the above
e. a. and c. only
Use the following information for questions 25 and 26. A bank has a planned 2-year investment horizon.
It is considering investing in a 2-year bond that pays 6% annually versus investing in a 4-year bond that
pays 6.5% annually and then selling it after two years. The annual coupon can be reinvested at 4%.
25. What will be the realized compound yield if the bank invests in the 2-year security and holds it until
maturity?
a. 4.00%
b. 5.48%
c. 5.94%
d. 6.01%
e. 6.85%
i = [(Price Received + Coupon Interest + Reinvestment Income)/Price Paid]1/n – 1
i = [($1,000 + (2 * $60) + ($60 * 4%))/$1,000]1/2 – 1 = .05943
26. What will be the realized compound yield if the bank invests in the 4-year security and sells it at the
end of two years, assuming interest rates remain unchanged?
a. 4.00%
b. 5.48%
c. 5.94%
d. 6.01%
e. 6.85%
Price Received after selling the 4-year security in 2 years:
FV = 1,000
PMT = $65
I=6
N=2
PV = ? = $1,009.17
i = [(Price Received + Coupon Interest + Reinvestment Income)/Price Paid]1/n – 1
i = [($1,009.17 + (2 * $65) + ($65 * .04))/$1,000]1/2 – 1 = .06854
27. If the Federal reserve is easing monetary policy at the end of a recession, as with the period after
2009, you would expect the yield curve to be:
a. upward sloping.
b. flat.
c. inverted.
d. humped.
e. none of the above
28. Classical economic theory suggests that if the economy is entering into a recessionary the yield
curve will be:
a. upward sloping.
b. flat.
c. inverted.
d. humped.
e. none of the above
29. A bank owns a zero coupon bond with 5 years to maturity and a face value of $10,000. If interest
rates increase from 6% to 7%, what is the approximate change in price, using Macaulay's duration?
a. $343
b. $352
c. -$343
d. -$352
e. not enough information is given to answer the question.
Price of Bond:
FV = 10,000
N=5
I=6
PV = ? = $7,472.58
ΔPrice ≈ - Duration * [Δi/(1+i)] * P
ΔPrice ≈ -5 * [.01/1.06] * $7,742.58 = -$352.48
30. In the above question, what is the approximate pricing error when using Macaulay's duration?
a. $8
b. $10
c. $12
d. $14
e. $16
Price of Bond:
FV = 10,000
N=5
I=7
PV = ? = $7,129.86
$7,129.86 - $7,472.58 = -$342.72
$352.48 - $342.72 = $9.76 ≈ $10.00
31. Securities with embedded options:
a. often have higher yields than comparable Treasury securities.
b. generally have no prepayment risk.
c. are always free of default risk.
d. all of the above.
e. a. and b. only
32. An investor can invest in either a tax-exempt security that pays 5% or a taxable corporate security of
comparable risk and maturity that pays 8%. At what marginal tax rate will the investor be indifferent
between these two securities?
a. 25.0%
b. 32.5%
c. 37.5%
d. 57.5%
e. 62.5%