Book 4. Liquidity and Treasury Risk

FRM Part 2

LTR 4. The Investment Function in Financial Services Management

Presented by: Sudhanshu

Module 1. Money Market and Capital Market Instruments

Module 2. Investment Security Selection and Risks

Module 3. Investment  Maturity Strategies and Maturity Management Tools

Module 1. Money Market and Capital Market Instruments

Topic 1. Compare various Money Market and Capital Market Investments

Topic 2. Money Market Investments

Topic 3. Capital Market Investments

Topic 4. More Recently Developed Investment Instruments

Topic 1. Compare various Money Market and Capital Market Investments

• Defining Financial Market Segments

​

• Key Investment Objectives for Financial Firms

  • Financial institutions invest in securities to meet multiple goals simultaneously:

1. Safety & Liquidity: Meeting sudden cash needs and regulatory requirements. This generally favors money market instruments.

2. Income & Return: Maximizing overall profitability through higher-yielding capital market instruments.

3. Tax Management: Selecting instruments whose income streams (e.g., municipal bonds) offer tax advantages.

4. Credit Quality: Ensuring investments meet minimum credit rating standards, often required by regulators.

5. Pledging Requirements: Holding eligible securities (like U.S. government and municipal debt) to collateralize public deposits.

Topic 2. Money Market Investments

• Money market instruments are short-term securities with maturities of one year or less, generally characterized by low risk and low yields. Banks and other depository institutions often invest in these securities for purposes like income stabilization, hedging risk, diversification, and liquidity. They can also be used as collateral for borrowing.

• Types of Money Market Investments

  • Treasury bills (T-bills): These are short-term, zero-coupon securities issued by the U.S. federal government, making them one of the safest investment vehicles. They are issued at a discount and mature at par, with the return being the difference between the two prices. Their main advantages are safety, liquidity, and their use as collateral.

  • Treasury notes (T-notes) and Treasury bonds (T-bonds): While T-notes and T-bonds are typically capital market instruments, they are classified as money market securities when they have one year or less remaining until maturity. They are also backed by the U.S. government and are coupon-bearing. They offer safety, secondary market liquidity, and potential for capital gains, with returns generally higher than T-bills.

  • Federal agency securities: These are issued by U.S. government-owned or sponsored agencies like Fannie Mae and Freddie Mac.

• Certificates of deposit (CDs): Issued by depository institutions, CDs are a source of funds for banks and offer investors a relatively low-risk, higher-yielding alternative to T-bills. Deposits are federally insured up to $250,000.

• International Eurocurrency deposits: These are uninsured time deposits with fixed maturities, primarily concentrated in London. They are considered low-risk and attractive to investors for their yield advantage over local bank time deposits, but have the disadvantage of volatile interest rates and taxable income.

• Bankers' acceptances: Used in trade finance, these are short-term, pure discount instruments where a bank guarantees a customer's payment. They have an active secondary market and offer higher yields than T-bills but lower than Eurocurrency deposits.

• Commercial paper: Large corporations issue this for short-term maturities, typically 90 days or less in the U.S.. Issued at a discount, their income is taxable.

• Short-term municipal obligations: Examples include tax-anticipation notes (TANs) and revenue-anticipation notes (RANs). A key advantage for investors is that the interest earned on these is exempt from U.S. federal income taxes.

Practice Questions: Q1

Q1. Which of the following characteristics is not an advantage of Treasury bills?

A. They have stable market prices.

B. They can serve as collateral for borrowers.

C. They have higher yields than agency securities.

D. They are backed by the taxing power of the federal government.

Practice Questions: Q1 Answer

Explanation: C is correct.

Treasury bills are very liquid short-term instruments backed by the taxing power of the federal government. They are liquid with stable prices and can be used as collateral for borrowing. They are considered safer investments than agency securities, and therefore have lower yields.

Practice Questions: Q2

Q2. Which of the following instruments is most common in trade finance transactions?

A. Commercial paper.

B. Bankers’ acceptances.

C. Tax-anticipation notes.

D. Certificates of deposit.

Practice Questions: Q2 Answer

Explanation: B is correct.

Bankers’ acceptances are short-term investments in which a financial firm like a bank guarantees the payment of a customer for an export/import transaction. These transactions are primarily used in trade credit (also called trade finance) deals.

Topic 3. Capital Market Investments

• Capital market instruments are securities with maturities greater than one year and are typically associated with higher risk and higher yield compared to money market instruments.

• Types of Capital Market Investments

  • Treasury notes (T-notes) and bonds (T-bonds): These are coupon-bearing securities issued by the U.S. federal government. T-notes have maturities up to 10 years and T-bonds have maturities over 10 years. Their advantages include safety, secondary market liquidity, and use as collateral. The main disadvantages are price risk from higher volatility and liquidity risk for less liquid issues.

  • Municipal notes and bonds: Issued by state and local governments, these are attractive to investors because the interest earned is exempt from U.S. federal income taxes. However, they are less liquid and are subject to capital gains taxes. There are two main types:

    • General obligation (GO) bonds: Backed by the full faith of the issuing government and paid from general revenues, such as taxes.

    • Revenue bonds: Issued to finance specific revenue-generating projects, with repayment coming from the project's revenues (eg. tolls from a toll road).​

• Corporate notes and bonds: These are debt securities issued by corporations. Corporate notes mature in up to five years, while corporate bonds mature in more than five years. Insurance companies and pension funds find them appealing for their higher yields compared to government-issued debt. This higher yield, however, is due to higher risk, and yields tend to widen during economic downturns.

Topic 4. Recently Developed Investment Instruments

• Over the last few decades, new investment securities have been created, including structured notes, securitized assets, and stripped securities.

• Types of Newer Investment Instruments

  • Structured notes: Created by dealers from federal agency security pools with yields resetting based on reference rates, featuring optional caps/floors and offering higher yields but increased complexity and loss potential

  • Securitized assets: Created from uniform loan pools (mortgages, credit cards) with higher yields, strong liquidity, and potential government/private guarantees, but popularity declined after 2007-2009 crisis exposed structural weaknesses

  • Pass-through securities: Issuing entity pools mortgages with trustee, passing principal and interest payments directly to investors, with potential payment guarantees from federal agencies like Fannie Mae and Ginnie Mae for a fee.

  • Collateralized mortgage obligations (CMOs): Developed by Freddie Mac, CMOs are pass-through securities that are divided into segments called tranches, each with a different level of risk and coupon rate.

  • Real estate mortgage conduits (REMICs): Segment mortgage cash flows into multiple maturity classes to reduce uncertainty, with primary risk being early mortgage prepayment by borrowers.

• Mortgage-backed bonds (MBBs): Unlike other securitized assets, the underlying mortgages for MBBs remain on the issuer's balance sheet, though they are segregated from other assets.

• Stripped securities: These are hybrid investments created when dealers "strip" a bond's cash flows into separate principal-only (PO) and interest-only (IO) securities.
• They are zero-coupon securities issued at a discount and maturing at par. They are attractive to investors as a hedge against interest rate changes.
• The most common bonds to be stripped are U.S. Treasury notes and bonds and mortgage-backed securities.

Module 2. Investment Security Selection And Risks

Topic 1. Various Factors that Affect the Choice of Investment Securities by a Bank

Topic 2. Expected Rate of Return

Topic 3. Tax Exposure

Topic 4. Interest Rate Risk

Topic 5. Credit Risk

Topic 6. Business Risk

Topic 7. Liquidity Risk

Topic 8. Call Risk

Topic 9. Prepayment Risk

Topic 10. Inflation Risk

Topic 11. Pledging Requirements

Topic 1. Factors Affecting a Bank's Choice of Investment Securities

• The Primary Investment Goals: Financial firms, particularly banks, must balance competing objectives when selecting investment securities:

1. Safety and Liquidity: Ensuring funds are available to meet cash needs, deposit withdrawals, and loan demands.
2. Income Generation: Maximizing the overall portfolio return to contribute to profitability.
3. Tax Management: Structuring the portfolio to minimize tax liability (e.g., using municipal bonds).

4. Credit Quality: Adhering to regulatory and internal standards regarding the acceptable level of default risk.

5. Pledging Requirements: Holding eligible securities as collateral for public deposits.

• The Trade-Offs: There is a continuous trade-off between Liquidity, Safety, and Yield.

  • Securities offering higher safety and liquidity (Money Market) generally offer lower yields. Securities offering higher yields (Capital Market, riskier assets) generally offer lower liquidity and higher risk.

Topic 2. Expected Rate of Return

• The  yield to maturity (YTM) is the best measure of expected return for most investment securities.

• It calculates the return an investor will receive if they hold the security until it matures, equating the present value of future cash flows with the security's market price.

• The YTM of a security should be compared to others to determine investment opportunities.

• For securities sold before maturity or those without a maturity date, the holding period yield (HPY) is a more suitable measure.

• The HPY calculates the return that equates the purchase price with the expected cash flows until the security is sold.

Topic 3. Tax Exposure

• Due to their high tax exposure, banks often focus on the after-tax returns of investments rather than before-tax returns.

• This is particularly important when comparing taxable and tax-exempt bonds, such as municipal bonds.

• To compare these on a pre-tax basis, a bank can calculate the tax-equivalent yield (TEY).

• Example: A bank with a 35% marginal tax rate is considering a corporate bond with a 6% YTM or a municipal bond with a 4.4% YTM.

  • Corporate bond after-tax YTM: $6\%\times (1-0.35)=3.9\%$ 

  • Municipal bond after-tax YTM: $4.4\%\times (1-0)=4.4\%$ (since it's tax-exempt)

  • Conclusion: The municipal bond is more attractive due to its higher after-tax yield.

• Tax-Equivalent Yield (TEY): For the municipal bond, the TEY would be $4.4\%/(1-0.35)=6.8\%$.

• Banks may also engage in tax swapping, a strategy that involves selling lower-yielding securities at a loss to reduce current taxable income and purchasing new higher-yielding securities.

Practice Questions: Q1

Q1. A bank recently purchased a municipal bond with a 5.5% nominal rate of return. To finance the purchase, the bank borrowed funds at a cost of 4.7%. The bank’s marginal income tax rate is 34%.

The bond is a bank-qualified bond, and 80% of the interest expense is tax deductible. The net after-tax return on the bond is closest to:

A. 0.80%.

B. 2.08%.

C. 2.40%.

D. 4.56%.

Practice Questions: Q1 Answer

Explanation: B is correct.

The after-tax return on municipal bonds can be calculated as:

Practice Questions: Q2

Q2. An investment firm that is prohibited from holding speculative grade securities would have to sell a security when its rating changes from:

A. AAA to AA.

B. BBB to BB.

C. BB to B.

D. B to CCC.

Practice Questions: Q2 Answer

Explanation: B is correct.

Investment firms like pension funds may be prohibited from holding speculative (noninvestment grade) securities. These securities are rated BB or below (Ba on a Moody’s scale). Firms can only hold securities rated BBB or above (Baa on a Moody’s scale).
The choices BB to B and B to CCC are incorrect because the investment firm would be prohibited from holding securities that are rated BB or B, so even if these securities’ ratings deteriorate further, they are ineligible investments. If a security’s rating drops from AAA to AA, it is still eligible for investment by the firm.

Topic 4. Interest Rate Risk

• Definition: The risk that changes in market interest rates will affect the market value of a security and/or the cash flow streams from that security.

• Inverse Relationship: Bond prices move inversely with interest rates. If rates rise, bond prices fall, leading to mark-to-market losses.

• Maturity/Duration Effect: The longer the security's maturity (or duration), the greater the interest rate risk. Banks often prefer shorter-term securities to reduce this exposure.

• Reinvestment Risk: The risk that income generated from a bond portfolio (e.g., coupon payments) will have to be reinvested at a lower rate.

Topic 5. Credit Risk

• Credit risk is the risk that an entity will be unable to make scheduled principal or interest payments or may default on its obligations.

• Credit rating agencies assign credit ratings to measure the relative credit quality of entities.

• Institutional investors, such as pension funds, are often restricted to holding only investment grade securities, which have a credit rating of BBB or Baa1 or higher.

• If a security's rating drops below this threshold (eg. to BB- or Ba), institutions can no longer hold it.

• The financial crisis of 2007-2009 highlighted a significant number of defaults on entities that were considered investment grade, exposing rating agencies to legal and reputational risks.

Topic 6. Business Risk

• Definition: The risk associated with general economic downturns or specific challenges within the issuer's industry (e.g., auto manufacturing, energy).

• Correlation: Business risk tends to be highly correlated across all non-government securities, especially during recessions.

• Mitigation: Banks attempt to mitigate this by diversifying the types of securities held across various economic sectors and issuers.

Topic 7. Liquidity Risk

• Liquidity risk is the risk that a security cannot be sold quickly and at a reasonable price, which could lead to potential losses.
• The depth and breadth of a security's resale market are crucial factors in a bank's purchase decision.
• There is often a trade-off between liquidity and yield.
• For instance, T-bills, T-bonds, and T-notes have superior liquidity but offer the lowest yields, which can lower a portfolio's overall return.

Topic 8. Call Risk

• Definition: The risk that a bond issuer will redeem a bond before its scheduled maturity date (Calling the bond).

• When it Occurs: Issuers call bonds when market interest rates fall, allowing them to reissue debt at a lower cost.

• Investor Impact: The investor (the bank) loses a high-yielding investment and must reinvest the principal at a lower, prevailing market interest rate. This is an adverse form of reinvestment risk.

Topic 9. Prepayment Risk

• Definition: The risk that borrowers will repay their loans sooner than expected, leading to an early return of principal to the investor.

• Primary Exposure: This is the most significant risk associated with Mortgage-Backed Securities (MBS) and Agency Bonds.

• Adverse Scenarios:

  • Falling Rates: Borrowers refinance at lower rates, causing prepayments to increase. The bank receives principal back when it is hardest to reinvest at a high rate.

  • Rising Rates: Borrowers delay moving/selling, causing prepayments to slow down. The bank is stuck holding a low-yielding bond when it could have reinvested at a higher rate.

Topic 10. Inflation Risk

• Definition: The risk that inflation will erode the purchasing power of the income and principal received from an investment.

• Fixed-Income Vulnerability: Fixed-rate bonds are particularly vulnerable because their future cash flows are set, while the value of money decreases.

• Mitigation Tool: TIPS: Treasury Inflation-Protected Securities (TIPS) are bonds whose principal value is adjusted based on changes in the Consumer Price Index (CPI), directly protecting the investor from unexpected inflation.

Topic 11. Pledging Risk

• Mandate: Depository institutions in the United States cannot accept federal, state, or local governments' deposits without posting collateral acceptable to these governments.

• Eligible Securities: Acceptable collateral must be of sufficiently high credit quality, typically limited to Federal and Municipal Securities.

• Strategic Impact: Banks must hold a dedicated, high-quality portfolio of these eligible securities, even if other investments offer higher, risk-adjusted returns, simply to qualify for lucrative public deposits.

• Other Uses: Pledging securities is also used to secure borrowing via repurchase agreements (Repos).

Module 3. Investment Maturity Strategies and Maturity Management Tools

Topic 1. Investment Maturity Strategies

Topic 2. Maturity Management Tools

Topic 1. Investment Maturity Strategies

• Goal: Financial firms must manage the maturity structure of their investment portfolio to meet both liquidity needs and profit objectives, while controlling Interest Rate Risk.

• Key Risk: The longer the average maturity of a portfolio, the greater the exposure to Interest Rate Risk.

• Three Primary Strategies: Banks generally adopt one of three strategies: the Laddered Strategy, the Front-Loaded (or Short-Term) Strategy, or the Back-Loaded (or Long-Term) Strategy.

• The Laddered Strategy

  • Structure: The portfolio is staggered across the maturity spectrum, with investments maturing at regular intervals (e.g., every 6 months or 1 year).

  • Advantages (Balanced Approach):

    1. Liquidity: Provides a steady stream of maturing investments to meet ongoing cash needs.

    2. Risk Mitigation: Less vulnerable to a single, adverse change in interest rates, as only a portion of the portfolio is affected at any given time.

    3. Income: Allows the firm to capture higher long-term rates while maintaining short-term liquidity.

• Best Used When: The bank is uncertain about the future direction of interest rates.

• The Front-Loaded (Short-Term) Strategy

  • Structure: Investment maturities are heavily concentrated in the short end of the maturity spectrum (e.g., 90 days to 1 year).

  • Advantages (High Liquidity, Low Risk):

    1. Safety & Liquidity: Maximum liquidity and minimum exposure to Interest Rate Risk.

    2. Flexibility: Allows the firm to quickly seize opportunities if interest rates rise (higher Reinvestment Risk).

  • Disadvantages: Sacrifice of income; accepts a high Reinvestment Risk when rates fall.

  • Best Used When: The bank anticipates interest rates will rise significantly.

• ​The Back-Loaded (Long-Term) Strategy

  • Structure: Investment maturities are heavily concentrated in the long end of the maturity spectrum (e.g., 5 to 10 years).

• Advantages (High Income):

  1. Maximizes Income: Captures the highest possible yields, assuming a normal, upward-sloping yield curve.

  2. Locks in Rates: Minimizes Reinvestment Risk by locking in high rates for a long period.

• Disadvantages: Lowest liquidity; maximum exposure to Interest Rate Risk (if rates rise, prices fall dramatically).

• Best Used When: The bank anticipates interest rates will fall or remain stable at high levels.

• Barbell Strategy

  • The barbell strategy combines the front-end and back-end load approaches.

  • A bank invests a significant portion of its funds in both very short-term and very long-term securities, while holding little to no intermediate-term bonds.

  • This creates a "barbell" shape when maturities are plotted. This strategy provides the liquidity of the short-term investments and the higher yields of the long-term ones.

  • It is a flexible approach that allows a bank to benefit from rising rates (by reinvesting short-term proceeds) and protect against falling rates (with locked-in long-term yields).

• Rate Expecttaions Approach

  • The rate expectations approach is the most speculative maturity strategy.

  • It relies entirely on a bank's ability to accurately forecast future interest rate movements.

  • If the forecast is for rising rates, the bank will adopt a front-end load strategy.

  • If the forecast is for falling rates, it will use a back-end load strategy.

  • This approach can lead to high returns if the predictions are correct, but it carries a substantial risk of loss if the market moves contrary to the bank's expectations.

Practice Questions: Q1

Q1. Which of the following investment maturity strategies would most likely reduce income fluctuation in the medium and long term, while generating sufficient ongoing liquidity for potential investment opportunities?

A. Ladder.

B. Barbell.

C. Back-end load.

D. Front-end load.

Practice Questions: Q1 Answer

Explanation: A is correct.

The ladder strategy involves investing an equal portion of securities in each maturity segment up until the maximum maturity desired. As investments in each interval mature, they free up cash which can then be used to take advantage of potential investment opportunities.
The other strategies either don’t provide ongoing liquidity or do not reduce income fluctuation in the medium or long term.

Topic 2. Maturity Management Tools

• The Yield Curve

  • Definition: A graph that plots the Yield-to-Maturity (YTM) of bonds of the same credit quality against their respective Maturity Dates.

  • Role in Strategy: The yield curve is the primary determinant of which maturity strategy is chosen:

    • Normal (Upward-Sloping): Encourages short-term investors to move to the long end for higher yield (Back-Loaded Strategy).

    • Inverted (Downward-Sloping): Suggests long-term rates are lower than short-term rates; encourages a Front-Loaded Strategy to maximize short-term yield.

  • Forward Rates: The yield curve is used to calculate implied forward rates, which are the market's expected future interest rates.

• ​Duration

  • Definition: A measure of a bond's price sensitivity to changes in interest rates. It is an effective measure of Interest Rate Risk.

    • Specifically, it is the weighted-average time until a bond's cash flows are received.

  • Relationship to Maturity: For a non-callable, zero-coupon bond, duration equals maturity. For coupon-paying bonds, duration is less than maturity.

• Role in Management:

  1. Risk Control: Portfolio managers use duration to control the exact level of interest rate risk, not just the maturity.

  2. Immunization: Duration can be used to immunize a portfolio against rate changes by matching the duration of assets to the duration of liabilities.

• Effective Duration: Used for securities with embedded options (like callable bonds or MBS) where the maturity and cash flows are not fixed.

• Immunization

  • Goal: A core strategy for risk managers to protect the net worth of a financial firm from interest rate changes.

  • Mechanism: Achieved by setting the average duration of the asset portfolio equal to the average duration of the liability portfolio.

  • Effect: When interest rates change, the market value of assets changes by the same dollar amount as the market value of liabilities, leaving the firm's net worth (equity) unchanged.