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Chapter Ten Chapter Ten

McGraw-Hill/Irwin
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Chapter Ten
The Investment Function in Banking
and Financial Services Management
The Investment Function in Banking
and Financial Services Management
Functions of a Banks Security
Portfolio
Functions of a Banks Security
Portfolio
Stabilize the Banks Income Over a
Business Cycle
Offset Credit Risk Exposure
Provide Geographic Diversification
Provide Backup Source of Liquidity
Reduce Tax Exposure
Serve as Collateral for Govt. Deposits
Hedge Against Interest Rate Risk
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Stabilize the Banks Income Over a
Business Cycle
Offset Credit Risk Exposure
Provide Geographic Diversification
Provide Backup Source of Liquidity
Reduce Tax Exposure
Serve as Collateral for Govt. Deposits
Hedge Against Interest Rate Risk
Money Market Instruments Used
by a Bank (Mostly for Liquidity)
Money Market Instruments Used
by a Bank (Mostly for Liquidity)
Treasury Bills
Short-Term Treasury Notes and Bonds
Federal Agency Securities
Certificates of Deposit
Eurocurrency Deposits
Bankers Acceptances
Commercial Paper
Short-Term Municipal Obligations
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Treasury Bills
Short-Term Treasury Notes and Bonds
Federal Agency Securities
Certificates of Deposit
Eurocurrency Deposits
Bankers Acceptances
Commercial Paper
Short-Term Municipal Obligations
Capital Market Instruments Used
by a Bank (Mostly for Income)
Capital Market Instruments Used
by a Bank (Mostly for Income)
Treasury Notes and Bonds Over One
Year to Maturity
Municipal Notes and Bonds
Corporate Notes and Bonds
Asset Backed Securities
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Treasury Notes and Bonds Over One
Year to Maturity
Municipal Notes and Bonds
Corporate Notes and Bonds
Asset Backed Securities
Other More Recent Investment
Instruments
Other More Recent Investment
Instruments
Structured Notes packaged investments
assembled by security dealers that offer
customers flexible yields.
Securitized Assets loans placed in a pool
and securities issued against that pool
Stripped Securities principal and interest
separated and each sold as a separate zero
coupon security
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Structured Notes packaged investments
assembled by security dealers that offer
customers flexible yields.
Securitized Assets loans placed in a pool
and securities issued against that pool
Stripped Securities principal and interest
separated and each sold as a separate zero
coupon security
Dominant Investments Held By
Bankspreferred securities
Dominant Investments Held By
Bankspreferred securities
Obligations of the U.S. Government and
Government Agencies
State and Local Government Obligations
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Obligations of the U.S. Government and
Government Agencies
State and Local Government Obligations
Factors Affecting the Choice of
Securities
Factors Affecting the Choice of
Securities
Expected Rate of
Return
Tax Exposure
Interest Rate Risk
Credit Risk
Business Risk
Liquidity Risk
Call Risk
Prepayment Risk
Inflation Risk
Pledging
Requirements
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Expected Rate of
Return
Tax Exposure
Interest Rate Risk
Credit Risk
Business Risk
Liquidity Risk
Call Risk
Prepayment Risk
Inflation Risk
Pledging
Requirements
Expected Rate of Return Expected Rate of Return
Yield to Maturity
Holding Period Return
security the of value face the is FV where
and security on the payments coupon annual the are CP where
YTM) (1
FV
YTM) (1
CP
PV
n
n
1
t
t
Bond

n
t
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Yield to Maturity
Holding Period Return
security the of value face the is FV where
and security on the payments coupon annual the are CP where
YTM) (1
FV
YTM) (1
CP
PV
n
n
1
t
t
Bond

n
t
held is security the years of number the is HP where
and for sold be can security the price the is P where
HPR) (1
P
HPR) (1
CP
PV
HP
1 t
HP
t

YTM Problem YTM Problem


A govt. bond is expected to mature in two
years and has a current price of $950.
What is the bonds YTM if the par value is
1000 and the coupon rate is 10%.
YTM = 12.99%=
If the bond is sold after 1 year for $970
what is the holding period yield.
YTM = 12.63
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A govt. bond is expected to mature in two
years and has a current price of $950.
What is the bonds YTM if the par value is
1000 and the coupon rate is 10%.
YTM = 12.99%=
If the bond is sold after 1 year for $970
what is the holding period yield.
YTM = 12.63
Tax Exposure Tax Exposure
The Tax Status of State and Local
Government Bonds
Bank Qualified Bonds
The Portfolio Shifting Tool
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The Tax Status of State and Local
Government Bonds
Bank Qualified Bonds
The Portfolio Shifting Tool
Interest Rate Risk Interest Rate Risk
Rising Interest Rates Lowers the Value of
Previously Issued Bonds
Longest Term Bonds Suffer the Greatest
Losses
Many Interest Rate Risk Tools Including
Futures, Options, and Swaps Exist Today
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Rising Interest Rates Lowers the Value of
Previously Issued Bonds
Longest Term Bonds Suffer the Greatest
Losses
Many Interest Rate Risk Tools Including
Futures, Options, and Swaps Exist Today
Default Risk Default Risk
Investment Grade
Moodys S&P
Aaa AAA
Aa AA
A A
Baa BBB
Speculative Grade
Moodys S&P
Ba BB
B B
Caa CCC
Ca CC
C C
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Investment Grade
Moodys S&P
Aaa AAA
Aa AA
A A
Baa BBB
Speculative Grade
Moodys S&P
Ba BB
B B
Caa CCC
Ca CC
C C
Business Risk Business Risk
Risk that the Economy of the Market Area
they Serve May Turn Down
Security Portfolio Can Offset This Risk
Securities Can be Purchased From Outside
Market Area Served
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Risk that the Economy of the Market Area
they Serve May Turn Down
Security Portfolio Can Offset This Risk
Securities Can be Purchased From Outside
Market Area Served
Liquidity Risk Liquidity Risk
Breadth and Depth of Secondary Market
Number of Trades on an Given Day
Volume of Trades on Any Given Day
Treasury Securities are Generally the Most
Liquid
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Breadth and Depth of Secondary Market
Number of Trades on an Given Day
Volume of Trades on Any Given Day
Treasury Securities are Generally the Most
Liquid
Call Risk Call Risk
Corporations and Some Governments
Reserve the Right to Retire the Securities
in Advance of Their Maturity
Generally Called When Interest Rates
Have Fallen
Investor Must Find New Security Often
with a Lower Return
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Corporations and Some Governments
Reserve the Right to Retire the Securities
in Advance of Their Maturity
Generally Called When Interest Rates
Have Fallen
Investor Must Find New Security Often
with a Lower Return
Prepayment Risk Prepayment Risk
Specific to Asset-Backed Securities
Most Consumer Mortgages and Loans
Can Be Paid Off Early
Caused by Loan Refinancing Which
Accelerate When Interest Rates Fall
Caused by Asset Turnover When
Borrowers Move or are Not Able to Meet
Loan Payments and Asset is Sold
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Specific to Asset-Backed Securities
Most Consumer Mortgages and Loans
Can Be Paid Off Early
Caused by Loan Refinancing Which
Accelerate When Interest Rates Fall
Caused by Asset Turnover When
Borrowers Move or are Not Able to Meet
Loan Payments and Asset is Sold
Inflation Risk Inflation Risk
Purchasing Power from a Security or Loan
May be Eroded by Rising Prices
Recently Developed Inflation Risk Hedge
Treasury Inflation Protected Securities
Both Coupon Payments and Principal
Adjusted Annually for Inflation Based on
Consumer Price Index
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Purchasing Power from a Security or Loan
May be Eroded by Rising Prices
Recently Developed Inflation Risk Hedge
Treasury Inflation Protected Securities
Both Coupon Payments and Principal
Adjusted Annually for Inflation Based on
Consumer Price Index
Pledging Requirements Pledging Requirements
Depository Institutions Cannot Accept
Federal, State and Local Government
Deposits Unless Acceptable Collateral is
Pledged
Generally Treasury Securities,
Government Agency Securities and
Selected Municipal Securities Can Be Used
as Collateral
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Depository Institutions Cannot Accept
Federal, State and Local Government
Deposits Unless Acceptable Collateral is
Pledged
Generally Treasury Securities,
Government Agency Securities and
Selected Municipal Securities Can Be Used
as Collateral
Investment Maturity Strategies Investment Maturity Strategies
The Ladder or Spaced-Maturity Policy
The Front-End Load Maturity Policy
The Back-End Load Maturity Policy
The Barbell Strategy
The Rate Expectation Approach
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The Ladder or Spaced-Maturity Policy
The Front-End Load Maturity Policy
The Back-End Load Maturity Policy
The Barbell Strategy
The Rate Expectation Approach
Maturity Management Tools Maturity Management Tools
The Yield Curve
Picture of How Market Interest Rates Differ
Across Differing Maturities
Constructed Most Easily with Treasury Securities
Provides Information About the Risk Return
Trade-Off
Duration
Present Value Weighted Average Maturity of the
Cash Flows
Can Be Used to Insulate the Securities From
Interest Rate Changes
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The Yield Curve
Picture of How Market Interest Rates Differ
Across Differing Maturities
Constructed Most Easily with Treasury Securities
Provides Information About the Risk Return
Trade-Off
Duration
Present Value Weighted Average Maturity of the
Cash Flows
Can Be Used to Insulate the Securities From
Interest Rate Changes
Maturity strategy problem Maturity strategy problem
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 investment maturity
strategy is each bank following? Why do you
believe that each of these banks has adopted the
particular strategy it has reflected in the
maturity structure of its portfolio?
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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 investment maturity
strategy is each bank following? Why do you
believe that each of these banks has adopted the
particular strategy it has reflected in the
maturity structure of its portfolio?
Maturity strategy answer Maturity strategy answer
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 a simple-to-execute strategy.
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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 a simple-to-execute strategy.
After tax yield on a qualified
municipal security
After tax yield on a qualified
municipal security
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
bank is in the 35 percent tax bracket?
Net After-Tax Return = (.06 - .05) + (0.35 x
0.80 x .05) = 0.024 or 2.4%
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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
bank is in the 35 percent tax bracket?
Net After-Tax Return = (.06 - .05) + (0.35 x
0.80 x .05) = 0.024 or 2.4%
After tax gross yield After tax gross yield
Suppose a corporate bond investment officer
would like to purchase a bond that 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 %( 1 - 0.35) = 5.84%.
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Suppose a corporate bond investment officer
would like to purchase a bond that 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 %( 1 - 0.35) = 5.84%.
Loan advantage Loan advantage
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. In this case the bank would accept a
somewhat 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
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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. In this case the bank would accept a
somewhat 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
Bond sale calculations Bond sale calculations
Spiro Savings Bank currently holds a
government bond valued on the day of its
purchase at $5 million, with a promised interest
yield (Coupon) of 6-percent, whose current
market value is $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?
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Spiro Savings Bank currently holds a
government bond valued on the day of its
purchase at $5 million, with a promised interest
yield (Coupon) of 6-percent, whose current
market value is $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?
Answer Answer
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 $0.715 million.
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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 $0.715 million.
What is Tax Swapping What is Tax Swapping
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 investment
securities at a loss to offset high taxable
income on loans or to replace taxable
securities with tax-exempt securities.
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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 investment
securities at a loss to offset high taxable
income on loans or to replace taxable
securities with tax-exempt securities.
Tax Swap Continued Tax Swap Continued
Portfolio switching 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.
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Portfolio switching 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.
Securities for Collateral
Requirements
Securities for Collateral
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
securities to meet these collateral requirements.
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.
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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
securities to meet these collateral requirements.
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.
Why Banks Face Pledging
Requirements
Why Banks Face Pledging
Requirements
Pledging requirements are in place to
safeguard the deposit of public funds.
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.
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Pledging requirements are in place to
safeguard the deposit of public funds.
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.
What Factors Affect Decisions on
Holding Different Maturities
What Factors Affect Decisions on
Holding Different Maturities
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.
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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.
How can yield curve and duration
help in the decision to sell or buy
How can yield curve and duration
help in the decision to sell or buy
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 under priced
or over priced securities. Finally, the yield curve's
shape gives the bank's investment officer a measure
of the yield trade-off - that is, how much yield will
change, on average, if a security portfolio is
shortened or lengthened in maturity.
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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 under priced
or over priced securities. Finally, the yield curve's
shape gives the bank's investment officer a measure
of the yield trade-off - that is, how much yield will
change, on average, if a security portfolio is
shortened or lengthened in maturity.
--- continued from previous slide --- continued from previous slide
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.
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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.
Calculate bond duration and
percent change in bond price
Calculate bond duration and
percent change in bond price
A bond currently selling 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 12 percent. What is
the bonds duration? Suppose interest
rates in the market fall to 10 percent.
What will be the approximate percent
change in the bonds price?
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A bond currently selling 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 12 percent. What is
the bonds duration? Suppose interest
rates in the market fall to 10 percent.
What will be the approximate percent
change in the bonds price?
---continued ---continued
CF PV@12% WT of each CF
1 $100 $89.30 (89.30* 1)= 89.30
2 $100 79.70 (79.70* 2)=159.40
3 $1100 783.20 (783.20* 3)=2349.6
total = 2598.3
Duration = 2598.3/950 = 2.7351
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CF PV@12% WT of each CF
1 $100 $89.30 (89.30* 1)= 89.30
2 $100 79.70 (79.70* 2)=159.40
3 $1100 783.20 (783.20* 3)=2349.6
total = 2598.3
Duration = 2598.3/950 = 2.7351
continued continued
The bond's duration is 2.7351 years. If
interest in the market falls to 10 percent,
the approximate percentage change in the
bond's price will be:
Percentage Change in Price = {-D x
Change in I /(1+I)} x 100
{-2.7351 x -.02/1+.12} x100 = 4.884 percent
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The bond's duration is 2.7351 years. If
interest in the market falls to 10 percent,
the approximate percentage change in the
bond's price will be:
Percentage Change in Price = {-D x
Change in I /(1+I)} x 100
{-2.7351 x -.02/1+.12} x100 = 4.884 percent
Net after tax yield on bank
qualified bonds
Net after tax yield on bank
qualified bonds
Tiger National 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 Youngstown 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 7.75%.
Tiger, which is in the top corporate tax bracket of 35
percent, must pay an average interest rate of 7.38% to
borrow the funds needed to purchase the municipals.
Would you recommend purchasing these bonds?
a) Calculate the net after tax return on this bank
qualified municipal security. What is the tax advantage
for being a qualified bond?
10-38
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
Tiger National 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 Youngstown 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 7.75%.
Tiger, which is in the top corporate tax bracket of 35
percent, must pay an average interest rate of 7.38% to
borrow the funds needed to purchase the municipals.
Would you recommend purchasing these bonds?
a) Calculate the net after tax return on this bank
qualified municipal security. What is the tax advantage
for being a qualified bond?
Answer to Net ATR problem Answer to Net ATR problem
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 A.T.R = (7.75% - 7.38%) + (0.80 x 0.35 x 7.38%)
= 7.75% -7.38% + 2.066%
= 2.436%
This net yield figure should be compared with other
investments of comparable risk on an after-tax basis.
However, the tax-exempt status of the income coupled
with the tax-deductibility of the interest expense make
these bonds a very attractive alternative.
10-39
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
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 A.T.R = (7.75% - 7.38%) + (0.80 x 0.35 x 7.38%)
= 7.75% -7.38% + 2.066%
= 2.436%
This net yield figure should be compared with other
investments of comparable risk on an after-tax basis.
However, the tax-exempt status of the income coupled
with the tax-deductibility of the interest expense make
these bonds a very attractive alternative.
TEY solution TEY solution
b) What is the tax equivalent yield for this
bank qualified municipal security?
TEY =7.75 +2.066/1-.35 = 15.10%
10-40
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e