Solution manual bank management and financial services 9th edition by rose, peter chap010

Chapter 10 - The Investment Function in Financial-Services Management

CHAPTER 10
THE INVESTMENT FUNCTION IN FINANCIAL-SERVICES MANAGEMENT
Goal of This Chapter: The purpose of this chapter is to discover the types of securities that
financial institutions acquire for their investment portfolio and to explore the factors that a
manager should consider in determining what securities a financial institution should buy or sell.
Key Topics in This Chapter








Nature and Functions of Investments
Investment Securities Available: Advantages and Disadvantages
Measuring Expected Returns
Taxes, Credit, and Interest-Rate Risks
Liquidity, Prepayment, and Other Risks
Investment Maturity Strategies
Maturity Management Tools
Chapter Outline

I.
II.
III.

IV.

V.

VI.
VII.

Introduction
Investment Instruments Available to Financial Firms
Popular Money Market Investment Instruments
A.
Treasury Bills
B.
Short-Term Treasury Notes and Bonds
C.
Federal Agency Securities
D.
Certificates of Deposit
E.
International Eurocurrency Deposits
F.
Bankers' Acceptances
G.
Commercial Paper
H.
Short-Term Municipal Obligations
Popular Capital Market Investment Instruments
A.
Treasury Notes and Bonds
B.
Municipal Notes and Bonds
C.

Corporate Notes and Bonds
Investment Instruments Developed More Recently
A.
Structured Notes
B.
Securitized Assets
C.
Stripped Securities
Investment Securities Held by Banks
Factors Affecting Choice of Investment Securities
A.
Expected Rate of Return
B.
Tax Exposure
1.
The Tax Status of State and Local Government Bonds
2.
The Impact of Changes in Tax Laws
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Chapter 10 - The Investment Function in Financial-Services Management

VIII.

IX.

X.

3.

Bank Qualified Bonds
4.
The Tax Swapping Tool
5.
The Portfolio Shifting Tool
C.
Interest Rate Risk
D.
Credit or Default Risk
E.
Business Risk
F.
Liquidity Risk
G.
Call Risk
H.
Prepayment Risk
I.
Inflation Risk
J.
Pledging Requirements
Investment Maturity Strategies
A.
The Ladder, or Spaced-Maturity, Policy
B.
The Front-End Load Maturity Policy
C.
The Back-End Load Maturity Policy
D.
The Barbell Strategy

E.
The Rate Expectations Approach
Maturity Management Tools
A.
The Yield Curve
1.
Forecasting Interest Rates and the Economy
2.
Risk-Return Trade-Offs
3.
Pursuing the Carry Trade
4.
Riding the Yield Curve
B.
Duration
1.
Immunization
Summary of the Chapter
Concept Checks

10-1. Why do banks and other institutions choose to devote a significant portion of their assets
to investment securities?
The primary function of most banks and other depository institutions is not to buy and sell
bonds, but rather to make loans to businesses and individuals. After all, loans support business
investment and consumer spending in local communities and provide jobs and income to
thousands of community residents.
However, many loans are illiquid—they cannot easily be sold or securitized prior to maturity.
And loans are among the riskiest assets, generally carrying the highest customer default rates of
any form of credit. Also, loan income is usually taxable for banks and selected other financial
institutions, necessitating the search for tax shelters in years when earnings from loans are high.

For all these reasons depository institutions, have devoted a significant portion of their asset
portfolios—usually somewhere between a fifth to a third of all assets—to another major category
of earning asset: investments in securities that are under the management of investments officers.
These instruments typically include government bonds and notes; corporate bonds, notes, and

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Chapter 10 - The Investment Function in Financial-Services Management

commercial paper; asset-backed securities arising from lending activity; domestic and
Eurocurrency deposits; and certain kinds of common and preferred stock permitted by law.
10-2. What key roles do investments play in the management of a depository institution?
Investment security portfolios perform many different roles that act as a necessary complement
to the advantages loans provide. They help stabilize income when loan revenues fall. Investment
in high-quality securities can be purchased and held to balance out the risk from loans.
Investment in securities allow the bank or thrift institution to diversify into different localities
than most of its loans permit, provide additional liquid reserves in case more cash is needed,
provide collateral as called for by law and regulation to back government deposits. Security
investments aid banks in reducing their exposure to taxes, and also help hedge against losses due
to changing interest rates. Investment securities, unlike many loans, can be bought or sold
quickly to restructure assets, hence providing flexibility to the banks. Over and above, the bank
managers can also dress up the balance sheet and make a financial institution look financially
stronger due to the high quality of many marketable securities.
10-3. What are the principal money market and capital market instruments available to
institutions today? What are their most important characteristics?
Banks purchase a wide range of investment securities. The principal money market instruments
available to banks today are Treasury bills, short-term Treasury notes and bonds, federal agency
securities, certificates of deposits issued by other depository institutions, international
Eurocurrency deposits, bankers' acceptances, commercial paper, and short-term municipal

obligations. The common characteristics of most these instruments are their safety and high
marketability. Capital market instruments available to banks include U.S. Treasury notes and
bonds, municipal notes and bonds, and corporate notes and bonds. The characteristics of these
securities are their higher expected rate of return and capital gains potential..
10-4. What types of investment securities do banks seem to prefer the most? Can you explain
why?
Commercial banks clearly prefer these major types of investment securities: U. S government
obligations, federal agency securities, and state and local government obligations, and assetbacked securities. They also hold small amounts of equities and other domestic and foreign debt
securities (mainly corporate notes and bonds).
They pick these types because they are best suited to meet the objectives of a bank’s investment
portfolio, such as a comparatively high yield, tax sheltering, reducing overall risk exposure, a
source of liquidity, and generating income as well as diversifying their assets.
10-5. What are securitized assets? Why have they grown so rapidly in recent years?
Securitized assets are loans that are placed in a pool and, as the loans generate interest and
principal income, that income is passed on to the holders of securities representing an interest in
the loan pool. These loan-backed securities are attractive to many banks because of their higher

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Chapter 10 - The Investment Function in Financial-Services Management

yields. Also, guarantees are received from government agencies (in the case of most homemortgage-backed securities) or from private institutions such as banks or insurance companies
pledging to back credit card loans. The loan-backed securities are also attractive because of their
relatively high liquidity and marketability of securities backed by loans compared to the liquidity
and marketability of loans themselves.
10-6. What special risks do securitized assets present to institutions investing in them?
Securitized assets often carry substantial prepayment risk, which arises when certain loans in the
securitized-asset pool are paid off early by the borrowers (usually because interest rates have
fallen and new loans can be substituted for the old loans at cheaper loan rates). Prepayment risk

can significantly decrease the values of securities backed by loans and change their effective
maturities, thus making the holder of the security receive diminished income.
Also, a substantial weakness among these securitized assets is that, there can be a sharp
deterioration in the underlying assets’ (loans) market values when they experience a significant
rise in default rates.
10-7. What are structured notes and stripped securities? What unusual features do they contain?
Structured notes usually are packaged investments, such as pools of federal agency securities,
assembled by security dealers that offer customers flexible yields in order to protect their
customers' investments against losses due to changing interest rates. Interest yield on such notes
could be reset periodically based on a reference interest rate, such as a U.S. Treasury bond rate.
Stripped securities represent a claim against either the principal or interest payments associated
with a debt security. The expected cash flow from a Treasury note, Treasury bond or mortgagebacked security is separated into a stream of principal payments and a stream of interest
payments, each of which may be sold as a separate security maturing on the day the payment is
due. In particular, stripped securities offer interest-rate hedging possibilities to help protect an
investment portfolio against loss from interest-rate changes.
10-8. How is the expected yield on most bonds determined?
For most bonds, determining the expected yield requires the calculation of the yield to maturity
(YTM), if the bond is to be held to maturity or the planned holding period yield (HPY) between
point of purchase and point of sale. YTM determines the yield on a bond that equalizes the
market price of the bond with its expected stream of cash flows.
However, many financial firms frequently do not hold all their investments to maturity. Some
must be sold off early to accommodate new loan demand or to cover deposit withdrawals. To
deal with this situation, the investments officer needs to calculate the holding period yield
(HPY). The HPY is simply the rate of return (discount factor) that equates a security’s purchase
price with the stream of income expected until it is sold to another investor.

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Chapter 10 - The Investment Function in Financial-Services Management

10-9. If a government bond is expected to mature in two years and has a current price of $950,
what is the bond's YTM if it has a par value of $1,000 and a promised coupon rate of 10 percent?
Suppose this bond is sold one year after purchase for a price of $970. What would this investor's
holding period yield be?
The relevant formula for YTM is:
$100
$100
$1,000
$950 =
+
+
1
2
(1 + YTM)
(1 + YTM)
(1 + YTM) 2

Using a financial calculator we determine the YTM to be 13 percent.
If the bond is sold after one year, the formula to find investor’s holding period yield is:
$100
$970
$950 =
+
1
(1 + HPY)
(1 + HPY)1
Therefore, the HPY when the bond is sold after one year is 12.63 percent.
10-10. What forms of risk affect investments?
The following forms of risk affect investments:

a.
interest rate risk,
b.
credit or default risk,
c.
business risk,
d.
liquidity risk,
e.
prepayment risk,
f.
call risk, and
g.
inflation risk.
Interest-rate risk captures the sensitivity of the value of investments to interest-rate movements
while credit risk reflects the risk that the security issuer may default on either interest or principal
payments. Business risk refers to the impact of credit conditions and the economy, where
delinquent loans may rise as borrowers struggle to generate enough cash flow to pay the lender.
Liquidity risk focuses on the price stability and marketability of investments. Prepayment risk is
specific to certain types of investments and focuses on the fact that some loans, which the
securities are based on, can be paid off early. Call risk refers to the early retirement of some
government and corporate securities and inflation risk refers to the possible loss of purchasing
power of interest income and repaid principal from a security or a loan.
10-11.
years?

How has the tax exposure of various U.S. bank security investments changed in recent

In recent years, the government has treated interest income and capital gains from most bank
investments as ordinary income for tax purposes. In the past, only interest was treated as

ordinary income and capital gains were taxed at a lower rate. Tax reform in the United States has

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Chapter 10 - The Investment Function in Financial-Services Management

also had a major impact on the relative attractiveness of state and local government bonds due to
declining tax advantages, lower corporate tax rates and fewer qualified tax-exempt securities.

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Chapter 10 - The Investment Function in Financial-Services Management

10-12. Suppose a corporate bond an investments officer would like to purchase for her bank
has a before-tax yield of 8.98 percent and the bank is in the 35 percent federal income tax
bracket. What is the bond's after-tax gross yield? What after-tax rate of return must a prospective
loan generate to be competitive with the corporate bond? Does a loan have some advantages for
a lending institution that a corporate bond would not have?
After-tax gross yield on corporate bond = 8.98 percent × (1 − 0.35) = 5.84 percent.
A prospective loan must generate a comparable yield to that of the bond to be competitive.
However, granting a loan to a corporation may have the added advantage of bringing in
additional service business for the bank that merely purchasing a corporate bond would not do.
Also, the management may desire to keep good loan customers, or there can be changes in the
state and local government credit quality. In such cases, the bank would probably be willing to
accept a lower yield on the loan compared to the bond in anticipation of getting more total
revenue from the loan relationship due to the sale of other bank services.
10-13. What is the net after-tax return on a qualified municipal security whose nominal gross
return is 6 percent, the cost of borrowed funds is 5 percent, and the financial firm holding the

bond is in the 35 percent tax bracket? What is the tax-equivalent yield (TEY) on this tax-exempt
security?
Net after-tax return on municipals (in percent) =
 Nominal return on municipals after taxes (in percent) 
 Interest expense incurred in acquiring the municipals (in percent) 


+ Tax advantage of a qualified bond
Tax advantage of qualified bond =
 The bank's marginalincome tax rate (in percent) ×

 Percentage of interest expense that is still tax deductible × 


 Interest expense of acquiring the municipals (in percent) 
Net after-tax return = (0.06 − 0.05) + (0.35 × 0.80 × 0.05) = 0.024 or 2.4 percent
Tax-equivalent yield =

After-tax return on a tax-exempt investment
 1 - Investing firm's marginal tax rate 

The security's tax-equivalent yield in gross terms:
6 percent
=
= 0.0923 or 9.23 percent.
 1 - 0.35
10-14. Spiro Savings Bank currently holds a government bond valued on the day of its
purchase at $5 million, with a promised interest yield of 6 percent, whose current market value is

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Chapter 10 - The Investment Function in Financial-Services Management

$3.9 million. Comparable quality bonds are available today for a promised yield of 8 percent.
What are the advantages to Spiro Savings from selling the government bond bearing a 6 percent
promised yield and buying some 8 percent bonds?
In this instance the bank could sell the 6-percent bonds, buy the 8-percent bonds, and experience
an extra 2 percent in yield. The bank would experience a capital loss of $1.1 million from the
bond's book value, but the after-tax loss would be only $1.1 million × (1 − 0.35) or $715,000.
10-15. What is tax swapping? What is portfolio shifting? Give an example of each.
A tax swap involves exchanging one type of investment security for another when it is
advantageous to do so in reducing the bank's current or future tax exposure. For example, the
bank may sell lower-yielding securities at a loss in order to reduce its current taxable income,
while simultaneously purchasing new higher-yielding securities in order to boost future returns
on its investment portfolio or to replace taxable securities with tax-exempt securities.
Portfolio shifting which involves selling certain securities out of a bank's portfolio, often at a
loss, and replacing them with other securities, is usually carried out to gain additional current
income, add to future income, or to minimize a bank's current or future tax liability. For example,
the bank may shift its holdings of investment securities by selling off selected lower-yielding
securities at a loss, and substituting higher-yielding securities in order to offset large amounts of
loan income, thereby reducing their tax liability.
10-16. Why do depository institutions face pledging requirements when they accept
government deposits?
Pledging requirements are in place to safeguard the deposit of public funds. At least the first
$100,000 of public deposits is covered by federal deposit insurance; the rest must be backed up
by bank holdings of U.S. Treasury and federal agency securities valued at their par values.
10-17. What types of securities are used to meet collateralization requirements?
When a bank borrows from the discount window of its district Federal Reserve Bank, it must
pledge either federal government securities or other collateral acceptable to the Fed. Typically,

banks will use U.S. Treasury and federal securities to meet these collateral requirements. Some
municipal bonds (provided they are at least A-rated) can also be used to secure the federal
government’s deposits in depository institutions.
If the bank raises funds through repurchase agreements (RPs), banks must pledge securities,
typically U.S. Treasury and federal agency issues, as collateral in order to borrow at the low RP
interest rate.
10-18. What factors affect a financial-service institution’s decision regarding the different
maturities of securities it should hold?

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Chapter 10 - The Investment Function in Financial-Services Management

In choosing among various maturities of short-term and long-term securities to hold, the
financial institution needs to carefully consider the use of two key maturity management tools—
the yield curve and duration. These two tools help management understand more fully the
consequences and potential impact on earnings and risk of any particular maturity mix of
securities they choose.
10-19. What maturity strategies do financial firms employ in managing their portfolios?
In choosing the maturity distribution of securities to be held in the financial firm’s investment
portfolio one of the following strategies typically is chosen by most institutions:
a. The Ladder, or Spaced-Maturity, Policy
b. The Front-End Load Maturity Policy
c. The Back-End Load Maturity Policy
d. The Barbell Strategy
e. The Rate Expectations Approach
The ladder or spaced-maturity strategy involves equally spacing out a bank's security holdings
over its preferred maturity range to stabilize investment earnings. The front-end load maturity
strategy implies that a bank will pile up its security holdings into the shortest maturities to have

maximum liquidity and minimize the risk of loss due to rising interest rates. The back-end loaded
maturity policy calls for placing all security holdings at the long-term end of the maturity
spectrum to maximize potential gains if interest rates fall and to earn the highest average yields.
The barbell strategy places a portion of the bank's security holdings at the short-end of the
maturity spectrum and the rest at the longest maturities, thus providing both liquidity and
maximum income potential. Finally, the rate expectations approach, the most aggressive of all
maturity strategies, calls for shifting maturities toward the short end if rates are expected to rise
and toward the long-end of the maturity scale if interest rates are expected to fall.
10-20. Bacone National Bank has structured its investment portfolio, which extends out to
four-year maturities, so that it holds about $11 million each in one-year, two-year, three-year, and
four-year securities. In contrast, Dunham National Bank and Trust holds $36 million in one- and
two-year securities and about $30 million in 8- to 10-year maturities. What maturity strategy is
each bank following? Why do you believe that each of these banks has adopted the particular
strategy it has as reflected in the maturity structure of its portfolio?
Bacone National Bank has structured its investment portfolio to include $11 million equally in
each of four one-year maturity intervals. This is clearly a spaced-maturity or ladder policy.
In contrast, Dunham National Bank holds $36 million in one and two-year securities and about
$30 million in 8- and 10-year maturities, which is clearly a barbell strategy.
Dunham National Bank pursues its strategy to provide both liquidity (from the short maturities)
and high income (from the long maturities), while Bacone National is a small bank that needs
less income fluctuations and a simple-to-execute strategy.

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Chapter 10 - The Investment Function in Financial-Services Management

10-21. How can the yield curve and duration help an investments officer choose which
securities to acquire or sell?
Yield curves possibly provide a forecast of the future course of short-term rates, telling us what

the current average expectation is in the market. The yield curve also provides an indication of
equilibrium yields at varying maturities and, therefore, gives an indication if there are any
significantly underpriced or overpriced securities. Finally, the yield curve's shape gives the
bank's investment officer a measure of the yield trade-off—how much yield can be earned
replacing shorter-term securities with longer-term issues, or vice versa.
Duration tells a bank about the price volatility of its earning assets and liabilities due to changes
in interest rates. Higher values of duration imply greater risk to the value of assets and liabilities
held by a bank. For example, a loan or security with a duration of 4 years stands to lose twice as
much in terms of value for the same change in interest rates as a loan or security with a duration
of 2 years.
10-22. A bond currently sells for $950 based on a par value of $1,000 and promises $100 in
interest for three years before being retired. Yields to maturity on comparable-quality securities
are currently at 12 percent. What is the bond’s duration? Suppose interest rates in the market fall
to 10 percent. What will be the approximate percent change in the bond’s price?
Period of
Expected
Cash
Flow
1
2
3

Expected
Cash Flow
from loan
$ 100
100
1,100

Present Value of

Annual Interest (at
12 percent YTM in
this case)
$ 89.29
79.72
782.96

Time Period
Cash Is to
Be
Received (t)
1
2
3

Present Value of
Expected Cash
Flows × t
$
89.29
159.44
2,348.87

PV of Cash Flows × t = $2,597.60
Hence, duration of the bond = $2,597.60 ÷ $950= 2.73 years
If interest in the market fall to 10 percent, the approximate percentage change in the bond's price
will be:
Δi
Percentage change in price  -D ×
(1 + i)

-0.02
= -2.73 ×
= -0.0488 or -4.88 percent
(1 + 0.12)
Therefore, the bond’s price will approximately reduce by 4.88 percent.

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Chapter 10 - The Investment Function in Financial-Services Management

Problems and Projects
10-1. A 20-year U.S. Treasury bond with a par value of $1,000 is currently selling for $1,025
from various securities dealers. The bond carries a 6 percent coupon rate with payments made
annually. If purchased today and held to maturity, what is its expected yield to maturity?
(Hint - the following relationships can help in solving for the yield:
If price < par value, then yield > coupon rate;
If price = par value, then yield = coupon rate;
If price > par value, then yield < coupon rate.)
Since the bond is selling at a premium, that is, price > par value, the yield will be less than the
coupon rate, or a yield < 6 percent.
The relevant formula for YTM is:
$60
$60
$60
$1000
$1,015 =
+
+ ... +
+

1
2
20
(1 + YTM)
(1 + YTM)
(1 + YTM)
(1 + YTM) 20
YTM = 5.79 percent (using a financial calculator.)
10-2. A municipal bond has a $1,000 face (par) value. Its yield to maturity is 5 percent, and the
bond promises its holders $60 per year in interest (paid annually) for the next 10 years before it
matures. What is the bond’s duration?
Annual
Interest
Income
$ 60
60
60
60
60
60
60
60
60
60
1,000

Year
1
2
3

4
5
6
7
8
9
10
10

PV of
Annual
Interest
$ 57.14
54.42
51.83
49.36
47.01
44.77
42.64
40.61
38.68
36.83
613.91
$1,077.22
PV of

PV
At 5%
0.95238
0.90703

0.86384
0.82270
0.78353
0.74622
0.71068
0.67684
0.64461
0.61391
0.61391

Annual

Year

×
×
×
×
×
×
×
×
×
×
×

Time
Period
Recorded
1

2
3
4
5
6
7
8
9
10
10

PV

Annual

Period

Income

@ 5%

Interest

Record
ed

60

2

60

0.9523
8
0.9070

=
=
=
=
=
=
=
=
=
=
=

Time

Interest

1

Time
Weighted
PV
$ 57.14
108.84
155.49

197.45
235.06
268.64
298.49
324.88
348.09
368.35
6,139.13
$8,501.56
Time
Weighte
d
PV

57.14

x

1

=

57.14

54.42

x

2

=

108.84

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Chapter 10 - The Investment Function in Financial-Services Management

3

60

4

60

5

60

6

60

7

60

8

60

9

60

10

60

10

1,000

3
0.8638
4
0.8227
0.7835
3
0.7462
2
0.7106
8
0.6768
4
0.6446
1
0.6139

1
0.6139
1

51.83

x

3

=

155.49

49.36

x

4

=

197.45

47.01

x

5

=

235.06

44.77

x

6

=

268.64

42.64

x

7

=

298.49

40.61

x

8

=

324.88

38.68

x

9

=

348.09

36.83

x

10

=

368.35

613.91

x

10

=

6139.13

1077.22

8501.56

Then, duration of the bond = $ 8,501.56 ÷ $1,077.22 = 7.89 years
10-3. Calculate the yield to maturity of a 20-year U.S. government bond that is selling for $975
in today’s market and carries a 5 percent coupon rate with interest paid semiannually.
The relevant formula for YTM is:
$975 =

$25
$25
$25
$1000
+
+ ... +
+
1
2
40
(1 + YTM/2)
(1 +YTM/2)
(1 + YTM/2)
(1 + YTM/2) 40

YTM/2 = 2.60 percent, YTM = 5.20 percent (using a financial calculator)

10-4. A corporate bond being seriously considered for purchase by Old Dominion Financial
will mature 20 years from today and promises a 7 percent interest payment once a year. Recent
inflation in the economy has driven the yield to maturity on this bond to 10 percent, and it carries
a face value of $1,000. Calculate this bond’s duration.
Annual
PV of
Interest
PV
Annual
Year Income at 10% Interest
1
$70 0.909 $ 63.64
2
70 0.826
57.85
3
70 0.751
52.59
4
70 0.683
47.81
5
70 0.621
43.46

×
×
×
×
×

Time
Period
Recorded
1
2
3
4
5
10-12

=
=
=
=
=

Time
Weighted
PV
$ 63.64
115.70
157.78
191.24
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Chapter 10 - The Investment Function in Financial-Services Management

6

7
8
9
10
11
12
13
14
15
16
17
18
19
20
20

70
70
70
70
70
70
70
70
70
70
70
70
70
70

70
1000

0.564
0.513
0.467
0.424
0.386
0.350
0.319
0.290
0.263
0.239
0.218
0.198
0.180
0.164
0.149
0.149

39.51
35.92
32.66
29.69
26.99
24.53
22.30
20.28
18.43
16.76

15.23
13.85
12.59
11.45
10.41
148.64
$744.59

×
×
×
×
×
×
×
×
×
×
×
×
×
×
×
×

6
7
8
9
10

11
12
13
14
15
16
17
18
19
20
20

=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
=

237.08

251.45
261.24
267.18
269.88
269.88
267.65
263.59
258.06
251.36
243.74
235.44
226.62
217.47
208.10
2972.87
$7,447.31

Therefore, the bond's duration is: $7,447 ÷ $744.59 = 10.002 years.
10-5. Forever Savings Bank regularly purchases municipal bonds issued by small rural school
districts in its region of the state. At the moment, the bank is considering purchasing an $8
million general obligation issue from the York school district, the only bond issue that district
plans this year. The bonds, which mature in 15 years, carry a nominal annual rate of return of
6.75 percent. Forever Savings, which is in the top corporate tax bracket of 35 percent, must pay
an average interest rate of 4.25 percent to borrow the funds needed to purchase the municipals.
Would you recommend purchasing these bonds?
Calculate the net after-tax return on this bank-qualified municipal security. What is the tax
advantage for being a qualified bond?
Because these bonds were issued by a small governmental unit issuing less than $10 million in
securities annually, the interest cost the bank has to pay to acquire the funds needed to buy these
bonds is tax deductible. Therefore, their net after-tax return is:

Net after-tax return on municipals (in percent) =
 Nominal return on municipals after taxes (in percent) 
 Interest expense incurred in acquiring the municipals (in percent) 


+ Tax advantage of a qualified bond
Tax advantage of qualified bond =
 The bank's marginalincome tax rate (in percent) ×


=  Percentage of interest expense that is still tax deductible× 
 Interest expense of acquiring the municipals (in percent) 
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Chapter 10 - The Investment Function in Financial-Services Management

Net after-tax retrun

= (0.0675 – 0.0425 ) + (0.35 × 0.80 × 0.0425)
= 0.025 + 0.0119
= 3.69 percent

This net yield figure should be compared with other investments of comparable risk on an aftertax basis. If the municipal bond described above had come from a larger state or local
government not eligible for special treatment under the Tax Reform Act, none of the interest
expense would have been tax deductible and the net tax advantage to the bank purchasing the
nonqualified bonds would be nil. Hence, the tax-exempt status of the income coupled with the
tax-deductibility of the interest expense makes these bonds a very attractive alternative.
10-6. Forever Savings Bank also purchases municipal bonds issued by the city of Richmond.
Currently the bank is considering a nonqualified general obligation municipal issue. The bonds,

which mature in 15 years, provide a nominal annual rate of return of 9.75 percent. Forever
Savings Bank has the same cost of funds and tax rate as stated in the previous problem.
a.

Calculate the net after-tax return on this nonqualified municipal security.

Net after-tax return = 9.75 percent – 4.25 percent = 5.50 percent
b.
What is the difference in the net after-tax return for this qualified security (Problem 5)
versus the nonqualified municipal security?
Net after-tax return (qualified security) – Net after-tax return (nonqualified municipal security) =
= 3.69 percent – 5.50 percent = 1.81 percent
Therefore, the net after-tax return from the qualified security is 1.81 percent less than the
nonqualified municipal security.
c.
Discuss the pros and cons of purchasing the nonqualified rather than the bank qualified
municipal described in the previous problem.
Clearly, the net after tax return for the nonqualified bond is higher than for the qualified bond.
On the other hand, nonqualified bonds are less liquid and thus, carry a higher liquidity risk. They
also tend to have a higher default risk, but that should already be priced into the yield of the
bond.
10-7. Lakeway Thrift Savings and Trust is interested in doing some investment portfolio
shifting. This institution has had a good year thus far, with strong loan demand; its loan revenue
has increased by 16 percent over last year’s level. Lakeway is subject to the 35 percent corporate
income tax rate. The investments officer has several options in the form of bonds that have been
held for some time in its portfolio:
a.
Selling $4 million in 12-year City of Dallas bonds with a coupon rate of 7.5 percent and
purchasing $4 million in bonds from Bexar County (also with 12-year maturities) with a coupon

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Chapter 10 - The Investment Function in Financial-Services Management

of 8 percent and issued at par. The Dallas bonds have a current market value of $3,750,000 but
are listed at par on the institution’s books.
b.
Selling $4 million in 12-year U.S. Treasury bonds that carry a coupon rate of 12 percent
and are recorded at par, which was the price when the institution purchased them. The market
value of these bonds has risen to $4,330,000.
Which of these two portfolio shifts would you recommend? Is there a good reason for not selling
these Treasury bonds? What other information is needed to make the best decision? Please
explain.
Under option (A), Lakeway will take an immediate $250,000 ($4 million − $3.75 million) loss
before taxes (or a loss of $162,500 after taxes) which can be used to help offset the high taxable
loan income earned this year. Moreover, the thrift will be able to earn 8 percent on an investment
of $4 million, or $320,000, in annual interest income compared to only $300,000 with the bonds
currently held or a gain in tax-exempt income of $20,000 per year. (Of course, if the thrift can
only afford to buy $3,750,000 in new municipals (the sale price of the old bonds) it will generate
about $300,000 in after-tax interest and have no net gain in tax-exempt interest income, but will
still have a tax-deductible loss on the sale of the old bonds.)
Under option (B), the U.S. Treasury bonds must be sold for a gain of $330,000 which is taxable
income. Because Lakeway does not need additional taxable income, Option B is less desirable
than Option A. Besides, the Treasury bonds are selling at a premium above par which indicates
their coupon rate is higher than current interest rates on investments of comparable risk,
suggesting the wisdom of retaining these bonds in the bank's portfolio either until loan revenues
decline and the bank needs additional taxable income or until interest rates rise well above
current levels and new securities appear that promise significantly higher interest yields.
10-8. Current market yields on U.S. government securities are distributed by maturity as

follows:
3-month Treasury bills
6-month Treasury bills
1-year Treasury notes
2-year Treasury notes
3-year Treasury notes
5-year Treasury notes
7-year Treasury notes
10-year Treasury bonds
20-year Treasury bonds
30-year Treasury bonds

=
=
=
=
=
=
=
=
=
=

1.90 percent
2.10 percent
2.25 percent
2.51 percent
2.82 percent
3.28 percent
3.56 percent

3.98 percent
4.69 percent
5.25 percent

Draw a yield curve for these securities. What shape does the curve have? What significance
might this yield curve have for an investing institution with 75 percent of its investment portfolio
in 7-year to 30-year U.S. Treasury bonds and 25 percent in U.S. government bills and notes with
maturities under one year? What would you recommend to management?

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Chapter 10 - The Investment Function in Financial-Services Management

The yield curve for U.S. Treasury bonds clearly slopes upward. Like most yield curves, this
curve does not become flat at longer maturities. A financial institution with 75 percent of its
portfolio in this 7- to 30-year range gains very little yield advantage over those institutions
holding shorter maturities in the form of 3-month bills to 5-year notes. Yet, the longer-term
bonds are less liquid so that a bank holding 7+ year maturities faces substantially greater
liquidity risk. This bank would probably be better off shifting its portfolio from 75 percent in
long-term securities into medium-term maturities.
10-9. A bond possesses a duration of 8.89 years. Suppose that market interest rates on
comparable bonds were 7.5 percent this morning, but have now shifted downward to 7.25
percent. What percentage change in the bond’s value occurred when interest rates decreased by
25 basis points?
Δi
(1 + i)
 -0.0025 
Percent Change in Value = -8.89 × 
 = 0.02067 or 2.067 percent

 1 + 0.075 
Percentage change in price  -D ×

10-10. The investments officer for Sillistine Savings is concerned about interest rate risk
lowering the value of the institution’s bonds. A check of the bond portfolio reveals an average
duration of 4.5 years. How could this bond portfolio be altered in order to minimize interest rate
risk within the next year?
Sillistine’s bond portfolio has an average duration of 4.5 years. This is relatively long, subjecting
them to substantial interest-rate risk. Shortening the duration of the portfolio or the use of
hedging tools (such as futures and options) is recommended.
10-11. A bank’s economics department has just forecast accelerated growth in the economy,
with GDP expected to grow at a 4.5 percent annual growth rate for at least the next two years.
What are the implications of this economic forecast for an investments officer? What types of
securities should the officer think most seriously about adding to the investment portfolio? Why?
Suppose the bank holds a security portfolio similar to that described in Table 10-3 for all insured
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Chapter 10 - The Investment Function in Financial-Services Management

U.S. banks. Which types of securities might the investments officer want to think seriously about
selling if the projected economic expansion takes place? What losses might occur and how could
these losses be minimized?
This economic forecast suggests that the current yield curve should be upward sloping and that
interest rates will rise over the next two years. In addition, loan demand should increase as the
economy expands suggesting that the bank may have to sell some of its investment portfolio in
the future to meet that demand. The investment officer would probably shorten the maturities of
the investment portfolio. An exception to this might be if the investment officer wants to ride the
yield curve by selling shorter term securities at a premium today and replacing them with longer
maturity securities with higher coupon rates. However, the investment manager must take into

account the risk of capital losses for the future with this strategy. The investment manager can
reduce his risks with the appropriate hedging tools as discussed in previous chapters.
10-12. Contrary to the exuberant economic forecast described in problem 11, suppose a bank’s
economics department is forecasting a significant recession in economic activity. Output and
employment are projected to decline significantly over the next 18 months. What are the
implications of this forecast for an investment portfolio manager? What is the outlook for interest
rates and inflation under the foregoing assumptions? What types of investment securities would
you recommend as good additions to the portfolio during the period covered by the recession
forecast and why? What other kinds of information would you like to have about the bank’s
current balance sheet and earnings report in order to help you make the best quality decisions
regarding the investment portfolio?
This economic forecast suggests that the current yield curve should be flat or downward sloping
and interest rates and inflation should fall over the next 18 months. In addition, loan demand
should decline in the future as output and employment decline. The portfolio manager should
lengthen the maturities of the investment portfolio and lock in higher rates now. However, the
investment manager should look at the bank’s current interest-sensitive gap and duration gap
position as well as their current earnings and tax status and consider these aspects of the bank’s
balance sheet before making any decisions.
10-13. Arrington Hills Savings Bank, a $3.5 billion asset institution, holds the investment
portfolio outlined in the following table. This savings bank serves a rapidly growing money
center into which substantial numbers of businesses are relocating their corporate headquarters.
Suburban areas around the city are also growing rapidly as large numbers of business owners and
managers along with retired professionals are purchasing new homes. Would you recommend
any changes in the makeup of this investment portfolio? Please explain why.
Types of Securities
Held

Percent of Total
Portfolio

U.S. Treasury securities

38.7%

Federal agency
securities

35.2

Types of
Securities Held
Securities
available for sale
Securities with
Maturities:

10-17

Percent of
Total Portfolio
45.6%
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Chapter 10 - The Investment Function in Financial-Services Management

Under one year
State and local
government obligations
Domestic debt

securities
Foreign debt securities
Equities

15.5
5.1

One to five years

37.9

Over five years

50.8

4.9
0.6

This bank is going to experience increasing loan demand in the future. This may mean increased
taxes in the future, increased liquidity risk and increased credit risk from its loan portfolio. To
help with the liquidity risk, the bank may want to consider shifting some of its portfolio from
securities with more than five years to maturity to shorter term securities. In terms of the
increased taxes and credit risk, it depends on which one of these is more important. The
proportion of the municipal bonds in this bank’s portfolio is already higher than the average bank
of its size. The bank may want to reduce its credit risk by reducing its state and local government
(municipal) bond portfolio. However, this bank does have other ways of reducing its credit risk
and it may want to decrease its taxability by increasing its investment in municipal bonds.

10-18