Report
Report
Report
Yields and Interest Rates Open market yields and interest rates fluctuate with supply and demand. Interest rates on investment securities vary widely depending on govt policy, business cycles, maturity, risk, tax status, and another factors. Another important influence of rates on investments is that movements in short-term rates do not always parallel movements in long-term rates. Generally, short-term rates on securities fluctuate more than long-term rates. When the economy is extremely active and interest rates are high, short-term rates move closer to long-term rates and at times may exceed long-term rates. Yields on Investment Securities Investments in fixed-income securities provided banks with two types of returns: periodic interest income and capital appreciation. Periodic interest income is derived from the accrual of semiannual interest earnings (interest earned but not paid until maturity) on notes and bonds and from cash payments at maturity for Treasury bills and other instruments purchased at a discount. Capital appreciation (or depreciation) results from selling an asset before its maturity at a price more (or less) than its original cost. If a fixed-income security is purchased from its original issuer and then sold before its maturity, changes in yields over the period of the security's maturity will change its market value, resulting in the appreciation or depreciation of bank capital. A bank purchases most of its investment securities for the yield or earnings they pay (although some investments are purchased more for their liquidity and marketability than for their yields). Yield is generally considered to be annual percentage rate of return received on an investment. Although several different types of yield can be calculated, yield is basically determined by dividing an investment instrument's annual return by the amount invested in it.
Bond Maturity, Interest Rate, Price, and Yield Under the terms of the contract by which a fixed rate note or bond is sold, the issuer of the security promises to pay interest on the amount of the debt at a stated rate and to
repay the principal amount of the debt on a specified date. The maturity of a note or a bond is the date on which the principal amount of the bond becomes due and payable. The interest rate or coupon of a bond is the stated annual interest rate of the issue and is expressed as a percentage of its face value. On fixed-rate bonds this rate remains fixed for the life of the instrument. Yield on a note or a bond is the rate of annual income accrued on the investment expressed as a percentage. It is important to note the distinction between interest rate (stated annual interest rate) and yield (annual income return). If an investor buys a bond at exactly its par value (usually states as 100, meaning 100 percent of the face value) and holds it to maturity or sells it at 100 before maturity, then yield or earnings will be exactly the same as the bond's interest rate (coupon). However, any bonds bought or sold at a price other than 100 (in other words, at a premium or a discount) will realize a yield different from the coupon. An investor buys or sells a bond at a price other than par because the terms of a fixed rate bond, including its interest rate, are normally set when the security is issued and cannot be changed by the bondholder. To sell a bond with a rate lower than the current rate, its price must be lowered enough to make its yield comparable to current yields. For example, assume that a bank holds a 20-year bond with a coupon of 7.5 percent and a par value of $1.000. At this interest rate, the bond earns $75 a year. If bonds of similar-quality risk and with the same time to maturity are currently offered at a 9 percent interest rate (earning $90 a year), no buyer will pay the bank the par price for the 7.5 percent bond. Instead, the bank must lower the price of the 7.5 percent bond so as to allow the buyer to realize an annual yield comparable to that of the current 9 percent bonds. On the other hand, the owner of a bond with a coupon higher than the current rate rate raises the selling price of the bond to lower its yield to the level of current yields. Thus, if current yields are 6 percent for comparable bonds, the holder of the older 7.5 percent bond would sell it only at a price above par because the bond earns more than is possible at current interest rates. In both cases, the yields of previously issued bonds are brought in line with current yields by changes in price.
Yield Measures
The following yield measures are used by investors to determine the yield from fixed income securities. Current yield It is simply the rate at which coupon income is earned. Mathematically, it is equal to the annualized coupon rate divided by the market price of the bond. Therefore, for discount bonds, current yield is greater than the coupon rate; for premium bonds, it is less than the coupon rate. Current yield is a simple measure it considers neither the return from
reinvestment of cash flows, nor the capital gain or loss due to price appreciation or depreciation. The current yield calculation can be improved by considering the capital gain or loss from a security. Modified current yield is defined is to be equal to the current yield of a security plus or minus the annual discount or premium amount (difference from par per year). This measure is an improvement over current yield, but it does not consider the time value of money. Yield to Maturity (YTM) It is an internal rate of return and if all cash flows generated by a security are discounted at this rate, the market price is achieved. Thus yield to maturity takes the time value of money into account. Unlike current yield, this measure incorporates both the reinvestments of coupon payments and any capital gain or loss. However, it assumes that all coupon flows are reinvested at a rate equal to the yield. As a result, yield may not be satisfactory for all circumstances, but it does serve as a market wide standard for relating the cash flows of a bond to its market value. Let us illustrate this point with a simple numeric example of the calculation of the return available a bond. Example Consider a bond with a coupon rate of 12% redeemable on 1/6/2001 selling at Rs. 80 on 1/6/1998. What is the return earned by the investor who buys the bond on 1/6/1998 and holds it till maturity? Many investors analyze the return earned in a very simple way. They reason that the total return consists of interest payments and the capital gain/loss on redemption. The average annual cash flow is then: Average annual cash inflow = Annual interest + Capital gain No. of years
For our example, the annual interest is Rs. 12, the total capital gain is Rs. 20, the annual capital gain is Rs. 6.67, the annual average cash inflow is Rs. 18.67, and the investment is Rs. 80.. Hence, the yield by this method works out to 18.67/80.0 = 23.33%. This calculation ignores the fact that the capital gains and the interest are received at different points of time. To compute an average cash inflow is not very meaningful. The correct way of computing the cash inflow is to consider the sequence of cash flows. An investor who buys the bond in 1998 incurs a cash outflow of Rs. 80 and receives
interest of Rs. 12. each in years 1993, 1994 and 1995. On maturity in 1995, he also receives Rs. 100. The structure of cash flow is thus: Date Cash flow 1/7/92 -80. 1/7/93 12. 1/7/94 12. 1/7/95 112.
The true return, known as the yield to maturity (or YTM) is the Internal Rate of Return (IRR) of this stream of cash flows. Using a calculator or a spreadsheet or other software on a computer, this YTM is readily calculated; it turns out to be appx. 22% as against 23.33% obtained by the shortcut method. Yield to First Call Some bonds are callable - that is, the issuer can redeem them at a call date before maturity, as specified in the bond contract. These bonds are known as bonds with embedded option. Investors calculate yield on these callable bonds to their first call date rather than their entire remain in term to maturity. Such calculations are called yield to first call. Banks purchase callable bonds because they often offer higher earnings than noncallable, or low-rate, bonds. Thus, higher earnings offset the lack of continuity or uncertainty of income of callable bonds. Such bonds are also called cushion bonds because both their higher yields and the premiums paid by their issuers in the event the call provision is exercised cushion the bank against the uncertainty of their income. Banks must also consider, however, that when yields fall on new issues, the prices of bonds that are immediately callable (or will be callable soon) increase less than those of non-callable bonds. An issue of bonds is most likely to be called for redemption when the issue's coupon is larger than the current yield on similar bonds. Therefore, investors calculate yield to maturity when the bonds are selling at a discount because the bonds are less likely to be called. When the bonds are selling at a premium (and are therefore more likely to be called), investors should calculated both yield to maturity and yield to first call and use the lower yield to evaluate their investment decision. In a rising market, investors are likely to demand higher yields on callable bonds to compensate for the possibility of losing the bonds to call by the issuer. Effective yield Effective yield is a measure for which the constraint of reinvesting cash flows at a security's yield is relaxed. This measure is the rate of return of a security achieved by reinvesting all coupon cash flows at a given reinvestment rate. The concept of effective yield also allows one to determine returns from a security to any chosen point in time known as the horizon date, which may or may not be equal to the maturity date.
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Because the horizon date is not always equal to the maturity date, a mechanism is required to evaluate the bond's salvage value at horizon. If the horizon date occurs prior to the maturity date, the future value of the investment has tow components: (1) the sum of each cash flow due before the horizon, reinvested at a given rate to horizon plus (2) the present value at horizon of all cash flows scheduled to occur after the horizon, discounted at another given rate (known as the horizon rate ). If the horizon date is beyond the maturity date, the future value of the investment is the sum of each cash flow reinvested at the given rate to maturity, then reinvested over the remaining investment periods to the horizon date. The effective yield is then computed by relating the future value of the security to the term of horizon. Realized Return The realized return (RR) on an asset refers to the total return earned on it over any specified time period. the different components of realized return are:.
1. 2.
Initial cost: The cost of buying the asset at the beginning of the period. Cash flows: The cash flows received from the asset during the period, including coupons and principal, both scheduled (as on maturity) and unscheduled (e.g., prepayments). Reinvestment income: The amount earned on reinvesting the cash flows received . This depends on interest rates when the cash flows are realized. Terminal value: The realized value of the asset at the end of the period. This depends on rates at the horizon date and on previous rate environments. For example, if a bond is called before the horizon, there is nothing left to sell.
3.
4.
The realized return over the period in question is now defined as: RR = Cash flows + Reinvestment Income + Terminal Value Initial Cost
Initial cost (price of bond at beginning of year) Cash flow (coupon income over the year) Reinvestment income (6 x 0.05) Terminal value (price of bond at end of year) Total accumulated value over the year Realized return = (107.30/100.00)-1= 7.30%.
= = = = =
BOND PRICING THEOREMS Theorem 1. The yields of previously issued bonds are brought in line with current market yields by changes in bond prices. A bond's yield will only be exactly the same as its coupon rate if the bond is bought at par value and then held to maturity or sold at par value before maturity. Therefore, there is a relationship between bond yields and bond prices because both factors interact. The yield relationships play an important role in investment decision-making. These relationships are referred to as bond pricing theorems. The bond theorems revolve around the relationship between price, yield to maturity and time to maturity. these relationships can be established with the help of following examples. Example1 : The YTM is 15% of a Rs. 1000 par value bond bearing a coupon rate of 10% and maturing in 10 years. Thus the market value of the bond would be 100PVIFA 15%,10 + 1000PVIF 15%,10 = 100 x 5.019 + 1000 x 0.247 = 501.9 + 247 = Rs. 748.9 If the YTM increase to 18%, the market value will reduce to Rs. 640.4 as shown below: = 100PVIFA18%,10 + 1000 PVIF18%,10 = 449.4 + 191 = Rs. 640.4 Example 1. Substantiates the first bond-pricing theorem.i.e The Inverse Relationship between Bond Price and Yield which simply means that the two move in opposite directions. In tight money periods when interest rates and bond market yields increase, the market prices of outstanding bonds decline; when rates and yields fall, the prices of outstanding bonds increase. The data in exhibit 1 shows this price yield relationship. If the level of market yields on 20-year bonds moves from 7 percent to 7.5 percent, the market price of a 7 percent bond will fall from 100 to 94.86; if yields drop to 6.5 percent, the price will go up to 105.55.
Exhibit 1.Prices of 7% and 7.5% Percent Bonds at Selected Maturities and Yields
Market Yield
7 Percent Bond
7.5 Percent
(Percent) 1 Year 5.00 6.00 6.50 7.00 7.50 8.00 9.00 101.93 100.96 100.48 100.00 99.53 96.06 98.13 5 Years 108.75 104.27 102.11 100.00 97.95 96.94 92.09 10 Years 115.59 107.44 103.63 100.00 96.53 93.20 86.99 20 Years 125.10 111.56 105.55 100.00 94.86 99.10 81.60
Theorem 2 Example 2: We assume two hypothetical bonds which have the same par value, same coupon rate and yield but only differing in its term to maturity. Face Value Coupon Rate YTM Years to Maturity Bond A 10% 5% 4 Bond B 10% 15% 8 1000 100PVIFA11%6+ 1000PVIF11%,6 =975.69 = -4.2%
Market Value at YTM at 1000 10% -(a) Market Value at YTM at 100PVIFA11%3+ 11%-(b) 1000PVIF11%3 = 975.56 = -2.5%
When YTM = coupon rate, market value of bond is equal to the face value This brings us to the second bond-pricing theorem i.e. All other factors remaining constant, the size of a bond's discount premium is directly proportional to its term to maturity. As the term to maturity decreases, the size of the discount/premium decreases. ,eg if two bonds are selling at the same par value, similar coupon rate and yield, the bond with the shorter life will sell for a smaller discount or premium. Theorem 3.
Example 3: Assume details of Bond B as given above at face value of Rs. 1000, coupon rate and YTM at 10% and maturity period at 6 years. If the YTM changes to 12% at the end of the fifth year, i.e. when the term to maturity of the bond is 1 year, the value of bond will reduce to Rs. 982.3. Similarly on calculating the price changes of the bond with different maturity period. Time to Maturity 1 2 3 4 5 Bond Price (Rs) 982.3 966.0 952.2 939.7 927.5 Change (%) 1.77 1.65 1.42 1.31 1.29
This proves our third bond-pricing theorem i.e. The interest rate risk of a bond increase at a diminishing rate as the time remaining until its maturity increase. Therefore, if the bond's yield does not change over its life, then the size of its discount/premium will decrease at an increasing rate as its life gets shorter. Theorem 4. Example 4: Assume a bond of maturity period of 6 years. (i) (ii) Rs. 1000 par value with coupon rate of 10% and
If YTM = 10%, market value of bond will be equal to the face value of Rs. 1000. A 2% increase in YTM to 12% changes price of Rs./ 918.10 (a decrease of 8.19%)
MV = 100PVIFA12%,6 + 1000PVIF12%,6 = 100 X 4.111 + 1000 X 0.507 = 411.1 + 507 = Rs. 918.10 (iii) A 2% decrease in YTM to 8% changes price to 1092.3 (an increase of 9.23%0
market value = 100PVIFA8%,6 + 1000PVIF8%,6 = 100 X 4.623 + 1000 X 0.630 = 462.3 + 630 = Rs. 1092.3 The example shows the fourth bond pricing theorem.
Asymmetrical price changes are a result of an equal sized increase or decrease in a bond's YTM. Therefore, for any given maturity, a decrease in yield causes a price rise that is larger than the price loss that results from the equal increase in yields. This property is called convexity
Yield Curves A yield curve is a visual representation of the relationship between yield and maturity for a homogeneous group of securities. Bankers often use yield curves to help them analyze financial markets and make sound investment decisions. Yield curves are simply graphs that show yields at a given time for securities that are similar except for their maturities. A yield curve is constructed from a listing of the market yields of one type of securities at one time. For eg. Treasury bills at the close of a day of market trading. Treasury securities are most often used to prepare yield curves because these securities share the same credit quality and have a wide variety of issues outstanding (thus giving a meaningful distribution of maturities); moreover the yields on government securities are basic to the financial markets. A yields curve can be drawn for any type of security as long as the issues are homogeneous, but yields of issues with different characteristics from the majority of those plotted on the graph will fall of the yield curve (rather than cluster in a pattern). Analyses of yield curves are important to investment decisions because they suggest trends in the changing economy that help investors decide on the best maturity to buy or sell.
Shape of Yield Curves Generally, the shape and level of yield curves do not remain constant over time. Supply and demand for money affects yield curves as much as investor expectation does. Yield curves usually shift and change in slope as interest rates rise and fall. There is usually a built-in upward bias in yield curves because of the liquidity premiums that lenders require as compensation for accepting additional price risk and less liquidity at the long end. Exhibit shows the variety of shapes yield curves may take:
Ascending, or upward-sloping, curve: This is to most common shape of yield curves; it tends to occurs in recessions or in periods of moderate economic expansion when yield levels are low and analysis expect an increase in yields.
10 9 YIELDS(%) 8 7 6 5 0
Series1
10
15
20
25
TERM TO MATURITY(YEARS)
Descending or downward sloping: This shape occurs during business booms and periods of inflation, when yields are high on short term securities and analysts expect lower yields in the longer term.
10
11 10 9 8 7 6 5
YIELDS(%)
Series1
10
15
20
25
TERM TO MATURITY(YEARS)
Humped curve: The shape (where yields are high at the short end, reach a peak, and then fall at the long end) usually occurs when the Treasury sells a larger volume of securities in a particular maturity range.
Series1
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Yield Spreads Yield spreads are differences between yields available on securities of comparable maturity but of varying quality and liquidity. Yields spreads change frequently, and they can be used to guide investment decisions on purchase or sales of securities of like maturity. When there is a significant increase or decrease in yields, the yields on all types of securities generally move in the same direction, although the yields on some securities change more than others. However, variations in yield levels have the greatest impact on yields of short-term securities and the least effect on yields of longterm securities. During an increase in yields, both types of securities will move in the same direction, but long-term yield typically will change much less than short-term yields. Also, while the yield increase on long-term investments will be less, the price decline change in rates for all maturities. Short-term bonds fluctuate more in yield than long-term bonds for a given change in prices. Long-term bonds fluctuate more in price than short-term bonds for a given change in yields. Because of this greater variability in long-term prices, some banks attempt to reduce long-term holdings when yields are expected to rise and increase these holdings when yields are expected to fall. The Use of Yield Spreads The use of yield spreads for investment strategy focuses on receiving adequate compensation for assuming added credit risk and/or less liquidity. However, this strategy does not take interest rate risk into consideration. For example, if a bank buys a 15-year municipal bond offering at the best relative yield available and yields on these bonds subsequently rise, the value of the purchase falls. The bank is somewhat protected against a price decline by having bought the best relative yield; but if yields increase significantly and there is a sizable price decline on such bonds this protection will be minor compared with possible losses. In other worlds, it would be a mistake to focus on yield spreads while ignoring the broader picture of projected yields levels based on the current movements of interest rates. Yield spreads can be particularly useful guides to the comparative values of securities for a bank that has made a commitment to purchase securities of a particular maturity. Commitments to purchase specific maturities are determined by the type of maturity distribution strategy used. If a bank modifies its maturity distribution strategies to recognize projected yield and price movements or if follows a cyclical approach, it will pay less attention to yield spreads and may choose not to take advantage of them at all in order to avoid interest rate risk
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Chapter 2 Duration, Convexity And Bond Volatility This chapter shall cover the cover the bond volatility concepts and applications. The effect of duration and convexity on bond volatility Has been shown with the help of examples.
Macaulay's Duration At the time of maturity of bonds, most bonds pay out the coupon payment as well as the final payments. A measure of the average time before receiving the payment is duration. In order to study the time structure of a bond, R.R. Macaulay suggested the usage of "duration" as a tool for the same. Duration is defined as "Weighted average of the lengths of time prior to the payments. The relative present values of the payments are used as weights". Duration is an important concept as it is a more meaningful alternative to measuring the length of a bond. It is also a direct measure of the sensitivity of bond prices to changes in interest rates. In order to calculate the duration of a single bond, a portfolio off diversified bonds or any other asset/liability which has predictable cash flows, Macaulay defined a formula which is given by
MD=
T = Time to maturity (fixed) T1 = variable tn = T F C = = 1 + YTM 1 + YTM Relative Value accounted for by the cash flows A. Periodic Coupon Bonds: Example
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Calculate MD for M/s dbs ltd. Given : YTM = 5%, Coupon rate = 8%, Time to Maturity = 3 years Face Value = Rs. 1000 Solution: 1 Year (t) 2 Cash flows (Rs.) 80 3 1/(1+YTM)t 4 5=44 6
PV of cash PV of cash =(5)x(1) flows = (2) x flows as (3) fraction of Po 76.184 0.0704 0.0704
80
72.56
0.0671
0.1342
1080
932.90
0.8625
2.5875
1081.64 = Po
1.0000
2.7921
The 3 year bond's duration is 2.7921 years. Thus, it can be seen that for the above bond, MD T. this is so as the investor recovers a part of his investment every year. As Given above, we can calculate the MD for a zero coupon bond.
1 Year (t) 1 2 3
3 1/(1+YTM)t
863.80 = 1 Po
The 3 year zero coupon bond has a duration of 3 years. Thus, MD = T as no intermediate recoveries are made by the investor.
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C. Perpetual Bond: For a perpetual bond, we assume the time to maturity (T) to be infinity. We can deduce the duration for the bond to be MD = Limiting Value MD or LMVD 1 +1 Where LMVD = YTM
MODIFIED DURATION Modified Duration (MMD) is defined as MMD = Macaulays duration 1+ YTM/p
Where P = Number of times per year the interest is paid., MD is Macaulay's Duration. Macaulay had devised a formula to calculate a bond's duration with which we were able to analyze the relationship between price and yield. In order to estimate a relationship between the duration of a bond and its volatility during a change of interest rates in the market, it can be given by % change in price = -MD (BP/100) Where MMD = Modified duration BP = Change in basis points (positive or negative) In our example of abc ltd he semi-annual bond has a duration of 2.7921 years, when the bond is giving YTM of 5%.
2.7921 = 2.7921 / 1.025 = 2.724 MMD = 1 + 0.05 / 2
If the bonds are yielding 7% to maturity and the same rate fall by 50 basis points to 6.5%, the percentage change will be calculated with as
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= - 2.724 (-50/100) = + 1.362 Consequently, if the bond sells for Rs. 1000.00 into yield 7%, it will raise to Rs. 1013.57 to yield 6.5% (a 1.357 percent increase).
Dollar Duration : Duration represents the percentage change in value in response to a change in rates. By weighting duration by the value of a holding, that is, by multiplying the market value of a holding by its duration (expressed as a decimal percentage), we get dollar-weighted duration, known as dollar duration. This number represents the actual dollar change in the market value of a holding in a bond in response to a percentage change in rates. When expressed as a dollar change per one basis point move in rate, dollar duration is sometimes called the price value of a basis point, or PVBP. Other than the factor of 100, there is no difference between dollar duration and PVBP.
Convexity: The Price Rate Relationship An understanding of convexity is critical to the accurate pricing and hedging of fixed income instruments. Convexity is a measure of the changing price response of a fixed income security as rates rise or fall. As such, it can be represented by the curvature exhibited in a price rate diagram (Figure .) A curve is said to be "convex" or to possess positive convexity when it is rounded like a segment of a circle viewed from the outside. It is "concave," or displays negative convexity, when it is rounded like a segment of a circle viewed from the inside. Convexity is zero for a straight line. Convexity, either positive or negative, is present when a security's price rate relationship is non-linear (Figure). A fixed income security has positive convexity if a 100-basis point rate reduction leads to a price increase that is larger than the corresponding price decrease if rates rise 100 basis points.
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Figure
For a semi annual pay bond whose next coupon is exactly six months from now.
Convexity =
4 PRICE
Where y is the annual coupon rate and CF are the periodic coupons. Given the convexity of a bond , modified convexity and the dollar convexity are computed as follows: Modified convexity = Convexity 1+y/2
Dollar convexity = modified convexity price The percentage price to convexity can be estimated using the following equation = modified convexity (yield change) 2 (100)2 Combining the price change due to duration and the price change due to convexity gives a considerably better approximation of the % change in the price. The convexity calculation in the case of a 20 year 10% coupon bond has been shown in the table.
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The application of the concepts has been shown in latter half of the study on the actual data obtained from the commercial banks.
Calcualtion of convexity for a 20 year 10% coupon bond selling at par to yield 10% period 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 cash flow 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 105 pv of $1 @5% 0.952380952 0.907029478 0.863837599 0.822702475 0.783526166 0.746215397 0.71068133 0.676839362 0.644608916 0.613913254 0.584679289 0.556837418 0.530321351 0.505067953 0.481017098 0.458111522 0.436296688 0.415520655 0.395733957 0.376889483 0.358942365 0.341849871 0.325571306 0.31006791 0.295302772 0.281240735 0.267848319 0.255093637 0.242946321 0.231377449 0.220359475 0.209866167 0.19987254 0.1903548 0.181290285 0.172657415 0.164435633 0.156605365 0.149147966 0.142045682 pv of cash flow 4.761904762 4.535147392 4.319187993 4.113512374 3.917630832 3.731076983 3.553406651 3.38419681 3.223044581 3.069566268 2.923396445 2.784187091 2.651606753 2.525339765 2.40508549 2.29055761 2.181483438 2.077603274 1.978669785 1.884447414 1.794711823 1.709249355 1.627856529 1.550339551 1.476513858 1.406203675 1.339241595 1.275468186 1.214731605 1.156887243 1.101797375 1.049330833 0.999362698 0.951773998 0.906451427 0.863287073 0.822178165 0.783026824 0.745739832 14.91479664 (period)2 1 4 9 16 25 36 49 64 81 100 121 144 169 196 225 256 289 324 361 400 441 484 529 576 625 676 729 784 841 900 961 1024 1089 1156 1225 1296 1369 1444 1521 1600 total = (period)2*pv 4.761904762 18.14058957 38.87269193 65.81619798 97.94077081 134.3187714 174.1169259 216.5885958 261.0666111 306.9566268 353.7309699 400.9229411 448.1215413 494.9665939 541.1442354 586.3827481 630.4487136 673.1434609 714.2997924 753.7789657 791.467914 827.276688 861.1361038 892.9955816 922.8211616 950.5936841 976.3071228 999.9670576 1021.58928 1041.198519 1058.827277 1074.514773 1088.305978 1100.250742 1110.402998 1118.820047 1125.561908 1130.690733 1134.270285 23863.67463 50006.19213
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convexity =
50006.19 4*100
=125.02
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Chapter 3
BASIC INGREDIENTS OF COMMERCIAL INVESTMENT POLICIES BANKS'
Investment policies differ among commercial banks because of differences in size, location, condition, and managerial capabilities. There are, however, four basic ingredients that should lead to sound and flexible investment policies in any bank: (1) Establishing general criteria and objectives for investment policies; (2) Inventorying the investment needs of the individual bank; (3) Formulating flexible policies and strategies and (4) Delegating authority while maintaining adequate control.
ESTABLISHING GENERAL CRITERIA AND OBJECTIVES
Investment policies generally should be in writing. Written policies provide continuity of approach over time, as well as concrete bases for appraising investment portfolio performance. The first section of the written portfolio policies should be a clear statement of the objectives of the investment portfolio. In the broadest sense, these are the same for all banks- to obtain income; to maintain high quality in the portfolio; to keep the bank's funds fully employed; to provide an adequate supply of securities for statutory requirements ; and to reduce tax liability to a practical minimum. INVENTORYING PORTFOLIO POLICY NEEDS FOR A BANK After the broad objectives have been established, bank management must formulate its bank's specific portfolio policies suited to the characteristics and conditions of the individual bank. There is a logical sequence of steps that management can take to inventory the portfolio policy needs of its bank. These steps are:
Identifying the Portfolio The bank should distinct the securities in the portfolio. The real distinction is the purpose for which the securities are held. Liquid assets are to meet estimates of potential deposit withdrawals and increased demands for loans. The investment portfolio, by contrast,
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represents the investment for surplus funds for income. The first step, therefore, in inventorying portfolio needs is to consider the two sets of assets separately.
Evaluating Pledging Requirements The commercial banks are required to pledge a specific portion of their net time and demand liabilities towards investments in sovereign obligations i.e. govt. and certain other approved securities. Such requirement plays an important role in investment decision making as only the surplus funds after such investments can be diverted towards other investment avenues. Hence the banks needs to look into its pledging requirement and the securities available for such investments. Assessing the Risk Position This decision will depend primarily on three considerations. The first is the amount of risk the bank has already assumed in its loan portfolio and other assets. The second is the bank capital position in relation to the assets it already holds. Bank management should determine whether it has capital in excess of the amount it should hold against its present and anticipated loans and other risk assets. The third consideration is a realistic evaluation of the amount of expertise available and effort applied to the investment portfolio area. Many small and medium-sized banks either do not have the necessary managerial investment expertise or they do not apply what expertise they do have to banking functions other than investment. The risk profile of the bank's portfolio would depend upon the above three factors Determining the tax position The fourth logical step in inventorying portfolio needs is to estimate a nearly as possible the bank's net taxable income, and to calculate the amount of additional tax-exempt income, if any, that the bank could profitably use by investments in securities that provide tax benefits.
Coordinating Investment and Liquidity Planning The fifth step in inventorying portfolio needs is to decide whether the bank's investment strategy should be coordinated with its liquidity position. Some banks, in effect, plan to provide funds to the investment portfolio in exchange for high-quality securities close enough to maturity to qualify as liquidity assets. Principally, banks that establish a policy of structured maturities follow this strategy. Other banks never plan for the liquidity portfolio to draw from the investment portfolio. Estimating the Need for Diversification
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The sixth and final step in the inventorying sequence is an estimation of the need for diversification. Investment additions in areas of heavy concentration might be limited; however, any advantages gained by diversification should be weighed against possible expertise of evaluate which bank management may have obtained in areas of concentrate.
Constructive policies and strategies will vary greatly among banks, and each bank should be sure to allow adequate flexibility for management discretion as conditions change. Investment Media and Quality Levels The essence of establishing flexible portfolio policies pertaining to in-vestment media and quality levels is matching the type and quality of investment portfolio instruments with the portfolio needs of the bank. Both the needs and the related policies .should be reviewed periodically. The first portfolio need affecting investment media is the level of the banks pledging requirements. Risk position will have a strong impact on the policies affecting the investment media and quality levels of the bank. Banks taking consider-able risks (in relation to their capital position) and banks lacking managerial expertise or effort should limit their purchases to government securities, state and local securities or corporate bonds given high rating. Many small banks, in particular, should adopt type of policy because of their limited senior managerial resources. Finally, if the bank feels that the advantages gained from diversification outweigh the advantages of expertise of evaluation which bank management has obtained in areas of concentration, policies should be formulated indicating the portfolio requirements for industrial or geographic diversification. Maturity Policies Maturities may present two types of policy problems: the establishment of a maximum maturity limit, if such should be considered sound policy; and the scheduling of maturities within the portfolio. The latter is closely related to the bank's appraisal of the economic climate. Arranging and rearranging portfolio maturities also bring the portfolio manager into the area of taking profits and losses.
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Maximum Maturity. There are two risk-related reasons that encourage some banks to limit the maximum acceptable maturities in their portfolio. First, the quality of state or local securities and corporate bonds may vary over time. A bank that lacks sufficient managerial expertise or time to evaluate the probability of deterioration in the quality of some securities in its portfolio may reduce its exposure to the risk by setting some fairly short-term limits on the maturities of such securities. The second reason pertains to interest rate movements. If interest rates rise, the price of longer-term bonds deteriorates much more than the price of short-term bonds. Instead of being able to purchase bonds at higher yields or fill expanding loan demands at profitable rates, the holders of long-term bonds have securities with large capital losses. "Never buy a yield that you are not willing to live with." In light of the uncertainties of a rapidly changing world, such advise might well limit portfolio commitments to no longer than ten years. Scheduling Maturities. Scheduling maturities within the investment portfolio is undoubtedly the most difficult and exacting task of portfolio management. Maturity policy, in contrast, requires constant review and decision-making as funds become available for investment or as opportunities to improve the income position present themselves. There are three major philosophies for scheduling maturities Cyclical maturity determination, Spaced or staggered maturities, "Barbell'' maturity structure.
. Under the cyclical maturity approach, banks hold (1). Short-term securities interest rates are expected to increase and (2). Long-term securities when rates are expected to decline This means that maturities are shortened when business conditions and loan demand are expected to increase leading to increase in the interest rates and maturities are lengthened when the signs of recession and decreased loan demand appear leading to slackening of the interest rates. The shortcomings of this approach include; (1) pressure for profits when interest rates are low, (2) dependence on the inconsistent behavior of business cycles, and (3) errors in forecasting swings in interest rates.
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The staggered maturity approach to portfolio maturity scheduling has been used to avoid some of the problems of the cyclical maturity approach. Under the staggered maturity approach, banks space maturities more or less evenly within the maximum portfolio maturity. Such a portfolio maturity structure provides average yields or better and avoids decisions based on expected changes in interest rates. If the yield curve is upward sloping, the reinvestment of funds from maturing securities at the longest end of the maturity distribution will provide maximum income on a portfolio with a reasonably short average maturity. The barbell approach to maturity scheduling is characterized by holding a portion of the portfolio in short-term, liquid securities and the remainder in long-term higher-yielding securities, Barbell portfolios tend to be trading-portfolios. The long term maturity portion of these portfolio Is larger when interest rates are high and the short term portion is larger when rates are low. Advocates of barbell portfolios believe their greater liquidity and higher returns more compensate for any additional risks. However successful use of this approach requires a high level of competence and judgment in the management of portfolios.
Liquidity Reserve Clarification System The most important traditional approach to managing the investment portfolio is the so called liquidity reserve classification system This method is useful in hedging the maturity composition of the bank investment portfolio in light of uncertainties concerning interest rates and management preferences. This version of the pool of-funds approach also illustrates the impact of liquidity considerations on the management of bank earning assets. Under the liquidity reserve system, each kind of investment is categorized by its degree of liquidity. Paralleling the asset categories, sources of asset flow uncertainty are divided into daily, weekly, seasonal and cyclical cash flows. These net cash outflows are assumed to have specific causes and are met from specific categories of reserve system investments. There are several categories of liquidity reserves. First, primary reservescash assets available to meet net cash outflows that occur in the normal course of daily banking activities. These are usually defined to include legal reserves; however, only excess cash is entirely
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available to meet the cash outflows. Second secondary reservesshort-term highly marketable government securities readily convertible into cash at or no risk of capital loss These securities include Treasury bills and Treasury notes and bonds which mature in the near future. This reserve provides liquidity to meet seasonal net cash outflows. Third, tertiary reservesprovide pro tection against major cyclical net cash outflows due to deposit withdrawals and/or increased loan demand occurring over a long period of time. Government securities with two to five-year ma turities could normally be included in this category since more emphasis can be placed on longer maturities and higher yields than in the more liquid secondary reserves. Fourth, investment reservesinclude securities with even longer maturities and higher yields to protect against cash outflows resulting from severe financial stress. The overall result of the liquidity reserve approach is a spacedmaturity portfolio heavily weighted by short-term securities. This approach generates reasonable (but not the highest) income levels without incurring risk of high capital loss. Split-Maturity Approach The split-maturity approach has been used to attempt to increase portfolio returns without increasing bank risk. This computer-based approach finds that the portfolio maturity distributions which produce the highest returns while controlling probable losses are those comprised of either all short-term securities all long-term bonds, or combinations of the two extremes("barbell" approach). These portfolios contain, for example, no securities with five to fifteen-year maturities. The securities with maturities up to five years are used to control capital losses and those with maturities over fifteen years are used to seek highest expected yields. The split-maturity approach is not a "cure all" for management. While this approach may result improved performance, management still needs to make decisions with respect to: 1.) Desired nature of the tradeoff between portfolio liquidity and stability. portfolio portfolio
portfolio income
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3) Incorporation of interest rate expectations into the portfolios maturity distributions. Portfolio managers should make these decisions consistent with overall objectives and expectations of bank performance.
RIDING THE YIELD CURVE: THE CONCEPT Riding the yield curve means the attempt to increase yield by acquiring a fixed-income security with a maturity longer than the expected holding period of the individual investor, and then selling the security prior to its maturiy such an activity could involve any form of fixed-income securities-corporate governments, and municipals, but the most common perception of riding the yield curve involves government securities, due to their superior marketability. Riding the yield curve could also be done with fixed-income securities of long maturity. However, this activity usually is confined to relatively shortmaturity issues, such as bills, since the goal is not to increase return in a speculative fashion but to increase the return over what could be earned by investing in a security with an original maturity equal to the holding period without accepting substantial risk. Successful implementation of the riding the yield curve strategy requires the existence of two conditions: The yield curve must be upward sloping that is it must be possible to obtain a higher expected yield by invested it in the long term rather than the short term.
The level of interest rates must not change move upward sufficiently to produce a capital loss on the longer term security sufficient to eliminate the yield advantage of investing in the longer term security rather than the shorter term issue. In essence success at riding the yield verve requires that the yield curve have a bias toward liquidity so that investors are will in to accept a lower return on the short term securities than on their longer term commitment of funds. The application of the concept has been shown on the actual data on banks investment in the latter part of the study.
Trading and Switching Securities. Most banks buy securities for their investment portfolio and put them away until they mature. This is not the way to maximize income consistent with reasonable levels of safety. There are times to buy and times to sell (and buy something else), and even the smallest bank can take advantage of the broad cyclical movements in the securities markets.
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One
can
make
valid
distinction
between
trading
and
switching.
Trading is a day-to-day operation that requires easy access to the markets and an expertise not available to most banks. Switching involves the mobility of a portfolio in relation to changes in economic conditions and related changes in rate levels. A bank that is alert to switching activities will be in the market far less than a bank that has the capacity to trade actively, but its purchases and sales can, nonetheless, add appreciably to its income over time.
AUTHORITY AND CONTROL The arrangements for the delegation of authority while maintaining control are an essential part of portfolio policy. The board of directors has the ultimate responsibility and should share responsibilities for the policy determination role with members of senior management. 'Hit-portfolio manager should be in charge of day-to-day management,6 and may recommend major courses of action or policy change to the board and senior management. A bank's investment policy should delegate specific authority to designated officers to purchase or sell securities up to certain amounts, just as a bank's loan policy should permit the bank's lending officer commit the bank for stated amounts. Opportunities for profitable switching or trading that may be evident to the investment officer or called to his attention by a correspondent bank, a dealer, or an investment advisory service do not last long in the market. If decisions must be referred to an Investment Committee, or even to a chief executive officer who may be away from the bank at the moment, profitable opportunities ill be irretrievably lost. A sound policy, therefore, will set trading limits based or the size of the bank and the investment officer's knowledge and experience, within which he should have full discretion. It is relatively simple to compare the results of trading, say every six months, with what would have resulted had no purchases or sales been made. Such a comparison should be a clear indication of the investment officers acumen.
The Role of the bank investment commttee: The man maintaining the bond portfolio has to be a first-rate director. His job is balancing the banks liquidity requirements against bank earnings. An important part of this balancing act involves shaping the maturity distribution of bond the balance of short intermediate and longterm issues-in the securities portfolio.
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There are no easy rules that will allow a banker to set a maturity distribution that enables him to meet cash outflows at a minimum cost. Sometimes short-term borrowings will be the cheapest and easiest source of funds. At other times the banker may be unable to use that market at all. Irregularities in the securities markets may make it advisable to raise cash by selling long-term rather than short-term bonds. A desire to take capital gains or capital losses may affect the selection of maturities to sell. Further, the choice of bonds to sell might depend on what the banker wants to leave in his securities portfolio for future liquidity protection. Despite the diverse circumstances, a bond portfolio manager's job in shaping the maturity distribution of the portfolio ultimately comes down to matching returns against risks. However, the bank portfolio manager faces the following problems. A Problem With Interest Rates Changes in interest rates cause changes in bank earnings and in the value of the portfolio. Thus, the vagaries of interest rates involve the portfolio of the manager in two kinds of troublesome risks: (1) the variations occurring in the interest income earned on bond investments, and (2) the capital losses resulting from an upward shift in market interest rates. Managing these risks can be particularly difficult because reducing the portfolio's exposure to one often increases exposure to the other. 2. Uncertainty With Top Management Not only does an account manager run into uncertainty from interest rates but also from top management. Portfolio managers may be unsure as to how their bosses weigh the risks of unstable portfolio income as opposed to capital losses. That is, how much management is willing to forego in potential earnings to avoid or reduce exposure to each type risk. Quite likely those evaluating a bond manager's performance will be less than elated by significant capital losses, and some will be even more unhappy if the capital losses have to be "realized" i.e the bond manager has to sell the securities at a loss to cover up the liquidity problems. These bankers usually try to keep realized losses at a minimum, because such losses stand out in the income statement. Thus, reporting them creates unfavorable publicity and embarrassment. This forces the portfolio manager to hold enough shortterm securities for instance Treasury bills which are virtually free of capital loss risks to cover any cash outflow likely to come down the pike Other portfolio managers may have to please bosses who are more concerned with the steadiness of the bank's overall income than with capital losses. This will encourage the portfolio manager to select more long-term bonds for the account. However, as income stability improves, the risk of capital losses climbs. Therefore, he will lengthen his maturities only as long as the combined effects create a more stable net income.
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He would normally keep supply of short-term securities sufficient to cover most cash drains with out severe capital losses.-He will also keep some longer maturities to steady the portfolio's interest earnings. Thus uncertainty about management views, on risk poses a difficult problem for the account manager in terms of balancing risks against returns.
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difficulty encountered finding a counterparty. Hence, a security is rendered illiquid given the adverse impact of the above mentioned factors Liquidity risk is a normal outcome of bank transactions as the bank invest short term funds in long term instruments, thereby creating maturity gaps between the assets and the liabilities. Thus the ban might face liquidty crunch in case of maturity of the liabilities. It is an indication of the financial flexibility of a bank to meet the liquidity requirements by disposing of liquid assts. Hence, the bank needs to have adequate liquidity in its investment portfolio. Interest Rate Risk(IRR) The management of Interest Rate Risk should be one of the critical components of market risk management in banks. The regulatory restrictions in the past had greatly reduced many of the risks in the banking system. Deregulation of interest rates has, however, exposed them to the adverse impacts of interest rate risk The Net Interest Income(NII) or Net Interest Margin (NIM) of banks is dependent on the movements of interest rates. Any mismatches in the cash flows (fixed assets or liabilities) or repricing dates (floating assets or liabilities), expose banks' NII or NIM to variations. The earning of assets and the cost of liabilities are now closely related to market interest rate volatility. Interest Rate Risk (IRR) refers to potential impact on NII or NIM or Market Value of Equity (MVE), caused by unexpected changes in the market interest rates. Interest Rate Risk can take different forms:
Gap or Mismatch Risk A gap or mismatch risk arises from holding assets and liabilities and off balance sheet items with different principal amounts, maturity dates or repricing dates, thereby creating exposure to unexpected changes in the level of market interest rates.
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Basis Risk Market interest rates of various instruments seldom change by the same degree during a given period of time. The risk that the interest rate of different assets, liabilities and off - balance sheet items may change in different magnitude is termed as basis risk. The degree of basis risk is fairly high in respect of banks that create composite assets out of composite liabilities,. The loan book in India is funded out of composite liability portfolio and is exposed to a considerable degree of basis risk. The basis risk is quite visible in volatile interest rate scenarios When the variation in market interest rate causes the NII to expand, the banks have experienced favorable basis shifts and if the interest rate monument causes the NII to contract, the basis has moved against the banks, Embedded Option Risk Significant changes in market interest rates create another source of risk to banks profitability by encouraging exercise of call/put options on bonds/debentures. The embedded option risk is becoming a reality in India and is experienced in volatile situations. The faster and higher the magnitude of changes in interest rate, the greater will be the embedded option risk to the banks' NII. Thus banks should evolve scientific techniques to estimate the probable embedded options and adjust the Gap statements (Liquidity and Interest Rate Sensitivity ) to realistically estimate the risk profiles in their balance sheet. Banks should also endeavor for stipulation appropriate penalties bases on opportunity costs to stem the exercise or options, which is always to the disadvantage of banks.
Yield Curve Risk In a floating interest rate scenario, banks may price their assets and liabilities based on different benchmarks, i.e. Treasury bills yields, call money rates, MIBOR, etc. In case the banks use two different instruments maturing at different time horizon for pricing their assets and liabilities, and non- parallel movements in Yield curves would affect the NII. The movements in yield curve are rather frequent when the economy moves through business cycles. Thus, banks should evaluate the movement in yield curves and the impact of that on the portfolio values and income. Price Risk
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Price risk occurs when assets are sold before their sated maturities. In the financial market, bond prices and yields are inversely related. The price risk is closely associated with the trading book, which is created for making profit out of short-term movements in interest rates. Banks which have and active trading book should, therefore, formulate policies to limit the portfolio size, holding period, duration, defeasance period, stop loss limits, marking it market, etc. Reinvestment Risk Uncertainty with regard to interest rate at which the future cash flows could by reinvested is called reinvestment risk. Any mismatches in cash flows would expose the banks to variations in NII as the market interest rates move in different directions. Net Interest position Risk The size of nonpaying liabilities is one of the significant factors contribution towards profitability of banks. When banks have more earning assets than paying liability, interest rate risk arises when the market interest rates adjust downwards. Thus, banks with positive net interest position will experience reduction in NII as the market interest rate decline and increases when interest rate rises. Thus, large float is a natural hedge against the variations in interest rates.
The Banks Portfolio It is true though that while risk cannot be avoided, it can at least be defined and managed, but this requires a clear understanding of the nature of a two parts : a basic liquidity reserve and a temporary investment of lendable funds. Although many banks do not separate the portfolio into these parts, they do exist and they have total distinct functions and management. The basic liquidity reserve is usually thought of as a pool of funds kept available for an emergency. But it has, in fact become a mandated fraction of total deposits that almost never falls below a determinable minimum. Thus, the capital risk is small and the reinvestment risk is large, which mitigates toward long maturity holdings. Unfortunately, that doesn't eliminate all risk. An interest rates rise and fall throughout the business cycle, the income risk in this part of the portfolio is substantial. The portfolio manager must
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perceive the large swings in interest rates in order to time his investments to coincide with the peaks in the business cycles. What is essential is to catch the large scale swings in interest rates, so that the yield on the portfolio is at the higher end of the range. That section of a bank portfolio which is a temporary investment of lend able funds is substantially more difficult to manage and a much riskier problem. Banks face a very predictable and difficult lending / investing cycle. As the primary financial intermediaries, banks tend to have funds in excess of their lending requirements when interest rates are low and bond prices are high . Conversely, they tend to have lending requirements in excess of their funds when rates are high and prices are low. Thus, the portfolio manager can almost be assured that the pressure to buy will be heaviest when prices are highest, and the pressure to sell will be heaviest when prices are lowest. It seems that the faces not only capital risk and reinvestment risk, but also income risk.
will be of even higher coupon, greatly reducing the possibility of capital loss, although not eliminating it completely. One the other hand, if the downturn lasts longer than expected, or the recovery is more anemic than expected, he will have a substantial reinvestment risk. He will be forced to reinvest the proceeds of matured holdings for necessarily short periods, and at necessarily low yields. At the same time, the new lower yield on the portfolio in a period of rising rates exposes him to large income risk. Hedging The other and less delicate, strategy involves hedging, particularly at the low yield end of the cycle. When the portfolio manager feels that there is under a year left before rates return to current levels, he does not reduce his maturities, but extends them; then he sells short an interest sensitive issue at the same item and in the same amount. Ideally, the short should have the same price volatility s the issue purchases, If rates start rising , the manager sells the investment, now at a loss and covers the short now at a profit, thus eliminating his capital risk. If rates hold or fall, the portfolio manager covers and resets his short, thus retaining the higher yielding investment to reduce both his reinvestment risk and income risk.
Diversification One of the most venerable rules of investment policy is diversification . If risk can not be avoided altogether it can at least be reduced to manageable proportions. If unanticipatable losses occur according to pure chance, then the holding of investment issues spread over a wide enough area will tend to reduce the losses to about their average probable value. But losses reduce to a random chance basis only when the elements of risk are independent and can be spread out. Risks of declining industries, or industries suddenly adversely affected by new developments, can be offset by diversification, and competitive changes where one company advances while another declines can also be offset in part. So diversification has a place in bank investment policy. The need for diversification in portfolios of state and local government securities is just as great as the need for spreading risk in portfolios of corporate obligations of state and local government securities is just as great as the need for spreading risk in portfolios of corporate obligations. Geographic diversification, however, is the principal form such risk spreading takes . Maturity distribution is logically a kind of diversification. To the extent that gains and losses on investment securities are due to changes in interest rates, a bank needs to
36
put new funds into the market at fairly regular intervals in order to average out the experience of the market. Diversification does not mean taking a little bit of every thing that comes along. Another false meaning of diversification is that of having a large number of securities . The major elements of diversification can be secured in a portfolio that can be listed on one sheet of paper. The advantages being able to follow each security carefully far out weight the advantages of more detailed diversification. One more false meaning is sometimes attached to diversification. Since diversification minimizes the risks that borrowers will not perform according to contract, the practice is more useful in dealing with middle grade than high-grade securities. Of course the highest grade can deteriorate , and so diversification is useful there too. But the most important feature of diversification is in dealing with investment which are not fully sheltered from risk. Probably the leading principle of diversification is that as far as possible, the bank should not duplicate its loan account Banks are generally not able to diversify loan accounts as much as they might wish. The loan accounts of most banks are concentrated geographically. Some banks, by virtue of an excellent connection through a director or an officer , may lend an unusual amount in a given industrial field. Duration Matching One method of matching assets and liability streams is to match their cash flows i.e. an inflow for every outflow. Such an approach however does not factor in shifts in the yield curve. A superior method to simple matching of cash flow is duration matching. In this method the liabilities can be matched by a portfolio of assets whose net present value and duration equals the equivalent liability. The advantage of such a matching of duration is that a single parallel shift in the yield curve would affect the asset and liability streams in equal measure. Once the portfolio has been formed, it is immunized from any adverse effects associated with future changes in the interest rates. Immunization & Interest Rate Risk Management A bond portfolio is said to be immunized if it is not very much affected by the adverse changes in interest rates. Immunization is accomplished by calculating the duration of the future outflows and then investing in a portfolio of bonds that has an identical duration. In a way, the capital loss risk due to rise in the interest rates and reinvestment risk due to fall in the interest rates arte counterbalanced. The basic principle used is that the duration of portfolio bond is equal to the weighted average of
37
the durations of the individual bonds in the portfolio. {The application of immunization has been explained later by taking the actual data of banks.}
Value at Risk Approach There is a gradual change where risk managers are using the mark to market approach for their investment portfolio. This is only a beginning because if still leaves unanswered the question of risk management. Lets take an example of managing of bank portfolio consisting of only govt, securities. Based on market movements (changes in the yield curve) , one can mark all the positions to market to determine the profit/ loss in the portfolio. As a manager , the next question is what should one about this potential loss/ gain . One would like to know if this change in the portfolios value is likely to remain constant, or increase or decrease over a certain time frame. What actions should one take? The answer is to obtain some quantifiable measure of the potential change in the portfolios value over a certain time horizon. Thus, one needs a way to move from ones portfolio expose as defined by the mark to market to the portfolio risk . We define a portfolio risk as a measure of the maximum potential change in the value of a portfolio of financial instruments with a given probability over a pre-set horizon. This term is commonly referred to as the value of Risk (abbreviated as VAR). In other words, VAR answers the question : How much can the portfolio lose / gain with P per cent probability over a given them horizon. The VAR approach also considers the interaction and correlation in the price movements of the different securities to determine the total loss or gain for the portfolio. This is different than a mere addition of the loss/gain of individual items in the portfolio as it considers the correlation amongst the different items. Approaches To Risk Estimation A number of different models are available and widely used by financial institutions in the US and Europe. Practitioners select a particular model based on their specific needs, the types of instruments they hold, their technical capabilities and the information systems structures . However , the primary difference between the different models is on two factors. What methods does the model use to predict the future market changes. What method the model uses to estimate the change in value of instruments as a result of market movements.
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Estimating Market Movement One of the common approaches for predicting market movements is to look at the past returns can be modeled to provide a reasonable forecast of future returns over different time horizons. The basic assumption made here is the returns in the past have a conditional normal distribution. In addition to using the past returns. This method also determines the relationships between different categories of financial instruments and uses covariance matrices to capture this information. Historical simulation methodology: Another approach used is the historical simulation methodology where no explicit assumption of the distribution of the asset returns is made . Portfolios are evaluated under a number of different historical time windows ranging from six months to year. The implicit assumption here is that the markets are cyclical in nature and the future behavior can be predicted if we can match with a similar cycle in the past. Stochastic simulation techniques It attempts to generate many more paths to market returns. The returns are generated using a defined stochastic process and statistical parameters that drive the process. For example , the stochastic process could be that interest rates follow a random path and the statistical parameters controlling the paths are the mean and variance of the random variable.
MEASURES OF INTEREST RATE RISK We measure interest rate risk by considering price sensitivity, that is the change in the value of the security ( or liability) in response to a change in interest rates. More precisely, price sensitivity is expressed as a percentage change in value for one percent (that is, one hundred basis point) change in interest rates. Different fixed income instruments have different levels of interest rate risk. Various risk measures are available, each with its own advantages and problems. Maturity. The term to maturity is an indicator of interest rate risk. Longer maturity bonds usually move more in price than shorter maturity bonds. However, this ordering does not always hold. Maturity takes into account only the timing of the final principal flow in a fixed rate bond, and ignores other cash flows. The actual interest rate sensitivity depends upon these factors and therefore, maturity, though sometimes useful, is only an approximate indicator of risk. Maturity is also not a cardinal measure, that is, it does not quantify risk.
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Dollar Duration : As we know, this number represents the actual dollar change in the market value of a holding in a bond in response to a percentage change in rates. When expressed as a dollar change per one basis point move in rate, dollar duration is sometimes called the price value of a basis point, or PVBP. Other than the factor of 100, there is no difference between dollar duration and PVBP. Convexity - As the market rallies (falling rates), for each successive basis point move down, the bond price increases at an increasing rate. Similarly, if rates increases and market declines the rate of decline above as rates rise. This property it is property in an asset since the price sensitivity changes in a way beneficial to the holder of the asset. In most situations, convexity is a second order effect, that is, its influence on the price behavior of a bond is small compared to that of duration. Instruments to counter interest rate risk:
(1)
Interest rate swaps represent a contractual agreement between the financial institution and another counterparty to exchange cash flows at periodic intervals based upon a national amount. The most common type of swap involves the payment of fixed rate cash flows by the financial institution (usually determined as a spread over the relevant maturity treasury rate) and receipt of floating rate cash flow. Such swaps (fixed rate payor-floating rate receiver) can be used by financial institutions to synthetically convert floating rate liabilities to fixed rate liabilities. This is possible because the floating cost of liabilities is counterbalanced by floating rate receipts associated with the swap. Any increases or decreases in liability costs are matched by similar changes in the floating rate inflows, as long as the national amount of the swap is equal to the principal amount of the liability cost at a rate equal to the fixed rate of the swap. The effectiveness of this strategy will depend upon the extent of basis risk between the liability rate and the swap floating rate index (usually LIBOR). For instance, if the eligibility rate increases by 1% and LIBOR only increases by 0.85%, the synthetic fixed rate will be higher by 0.15%. Conversely, if the liability rate increases by 0.85 while LIBOR increase by 1% , the synthetic liability rate will be lower than the swap fixed rate by 0.15% . The synthetic funding rate will also be affected by any discrepancies in the repricing frequency of the liability and the reset period of the swap. A similar strategy using reverse swaps, where the financial institution receives fixed rate cash flows and pays floating rate cash flows can be used to convert the fixed cost of liabilities to a synthetic floating rate. In this case, the fixed rate interest cost of the liability is offset by the fixed rate inflows of the swap. If the
(2)
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liability rate is higher (lower) than the swap fixed rate, then the synthetic floating rate will be higher (lower) than the swap floating rate. Interest rate swaps, which usually involve the exchange of floating rate cash flows based upon different indices can be used to manage the basis risk between two instruments. For instance, a financial institution with a reference of LIBOR indexed cash flows rather than Treasury rate indexed cash flows could synthetically convert the Treasury cash flows to LIBOR based cash flows. This is accomplished by entering into a basis swap, which involves the payment of Treasury based payments and the receipt of LIBOR indexed cash flows.
(3) Interest Rate futures Hedging with financial futures involves taking offsetting positions in the futures market such that any losses (gains) in the value of the cash financial instrument (asset or liability) is counter balanced by gains (losses) in the value of the futures contracts. Note that the protection, provided by financial futures is symmetric in that losses (gains) in the value of the cash position are offset by gains (losses) in the value of the futures position. Financial futures may be used either to protect asset returns or lock in liability costs for financial institutions. In asset hedging, any losses (gains) in market value due to a rise (fall) in interest rates can be offset by similar gains (losses) in the value of the futures contracts. The type of financial futures instruments will be determined primarily by the characteristics of the instrument being hedged. This is usually accomplished by selecting the financial futures instrument which exhibits the highest degree of correlatio with price changes of the cash instrument being hedged. Another important factor in this selection process is the degree of liquidity in secondary market trading as the effectiveness of the futures hedge is highly dependent upon the ability to terminate the futures position without incurring excessive transactions costs. (4) Options Options represent an agreement between two parties in which the buyer of the option is given the right to buy (sell) an asset while the seller or writer of the option assumes the obligation to sell (buy) the asset. In exchange for the right to exercise the right for a specified period of time, the option buyer pays the option seller an up front premium. With respect to fixed income portfolio management, options can be purchased on physical instruments such as Treasure bonds and
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mortgage-backed securities and on futures contracts. While an option on a physical contract confers the right to buy (sell) the cash instruments, the underlying instrument associated with options on futures is the futures contract (5) Customized Interest Rate Agreements Customized interest rate agreements is the general term used to classify instruments such as interest rate floors. Interest rate floors allow the purchaser of he floor to protect the return associated with a floating rate asset. The purchaser of the floor receives from the seller of the floor, any amount below the protected rate at the periodic settlement of the floor. In return for the protection against falling asset returns, the floor buyer pays a premium o the seller of the floor. The payoff profile of the floor buyer is also asymmetric in nature since the maximum loss is restricted to the floor premium. A interest rates fall, the payoff to the buyer of the floor increased directly proportional to the fall in rates. In this respect, the purchase of a floor is analogous to the purchase of a strip of call options.
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Chapter 5 Indian Money And Debt Market Investment Instruments Different kinds of debt instruments and their key terms and characteristics are discussed below.
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CDs are marketable receipts in bearer or registered form of funds deposited in banks for a specified period at a specific rate of interest. Banks are allowed to issue CDs with a maturity of less than one year . The market is most active for the one year maturity bracket, while longer dated securities are not much in demand. One of the main reasons for an active market in CDs is that their issuance does not attract reserve requirements since they are obligations issued by a bank. Treasury Bills (T-Bills): Treasury bills are short term money market instruments used by the government to finance its short term financial requirements. These are issued by the Reserve Bank of India on behalf of the Government of India and are thus actually a class of Government Securities. Potential investors have to put in competitive bids at the specified times. These bids are on a price/interest rate basis. The auction is conducted on a French auction basis ie all bidders above the cut off at the interest rate/price which they bid while the bidders at the clearing/cut off price/rate get pro rata allotment at the cut off price/rate. The cut off is determined by the RBI depending on the amount being auctioned, the bidding pattern etc. By and large, the cut off is market determined although sometimes the RBI utilizes its discretion and decides on a cut off level which results in a partially successful auction with the balance amount devolving on it. This is done by the RBI to check undue volatility in the interest rates.Non-competitive bids are also allowed in auctions (only from specified entities like State Governments and their undertakings and statutory bodies) wherein the bidder is allotted T-Bills at the cut off price.
YIELD-CALCULATION
The yield of aT-Bill is calculated as per the following formula: (100-P)*365*100 Y= ---------------------P*D Wherein Y = Discounted yield P = Price D = Days to maturity
Short-Term Debentures are issued by corporate entities. However, unlike CPs, they represent additional funding for the corporate ie the funds borrowed by issuing short term debentures are over and above the funds available to the corporate from its consortium bankers.
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Fixed deposits: These are the deposits made normally with the banks and carry a specified maturity date and rate of interest. These are assumed to be risk free and hence the return offered is lower than the market determined rate on other securities. Flexi deposits: These are a type of fixed deposits whereby the entire deposit amount is divided into several equal parts. This is done so as to make it possible for the depositor to withdraw amount without withdrawing the entire fixed deposit with the bank.
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attract stamp duty or transfer fee. Also no tax is deductible at source on the coupon payments made on GOISECs. Like T-Bills, GOISECs are issued through the auction route. The RBI pre specifies an approximate amount of dated securities that it intends to issue through the year. However, it has broad flexibility in exceeding or being under that figure. Unlike T-Bills, it does not have a pre set timetable for the auction dates and exercises its judgement on the timing of each issuance, the duration of instruments being issued as well as the quantum of issuance. Sometimes the RBI specifies the coupon rate of the security proposed to be issued and the prospective investors bid for a particular issuance yield. The difference between the coupon rate and the yield is adjusted in the issue price of the security. On other occasions, the RBI just specifies the maturity of the proposed security and prospective investors bid for the coupon rate itself. In either case, just as in T-Bills, the auction is conducted on a French auction basis. Also, the RBI has wide latitude in deciding the cut off rate for each auction and can end up with unsold securities, which devolve on itself. Apart from the auction program, the RBI also sells securities in its open market operations (OMO) which it has acquired in devolvements or sometimes directly through private placements. Similarly, it also buys securities in open market operations if it feels fit. New types of GOISECs Earlier, the RBI used to issue straight coupon bonds ie bonds with a stated coupon payable periodically. In the last few years, the RBI has been innovative and new types of instruments have also been issued. These include Inflation linked bonds: These are bonds for which the coupon payment in a particular period is linked to the inflation rate at that time the base coupon rate is fixed with the inflation rate (consumer price index-CPI) being added to it to arrive at the total coupon rate. Investors are often loath to invest in longer dated securities due to uncertainty of future interest rates. The idea behind these bonds is to make them attractive to investors by removing the uncertainty of future inflation rates, thereby maintaining the real value of their invested capital. Zero coupon bonds: These are bonds for which there is no coupon payment. They are issued at a discount to face value with the discount providing the implicit interest payment. In effect, these can be construed as long duration T Bills or as bonds with cumulative interest payment.
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State government securities (state loans) : These are issued by the respective state governments but the RBI coordinates the actual process of selling these securities. Each state is allowed to issue securities up to a certain limit each year. While there is no central government guarantee on these loans, they are deemed to be extremely safe. Generally, the coupon rates on state loans are marginally higher than those of GOISECs issued at the same time. The procedure for selling of state loans, the auction process and allotment procedure is similar to that for GOISEC. They also qualify for SLR status and interest payment and other modalities are similar to GOISECs. They are also issued in dematerialized form and no stamp duty is payable on transfer. The procedure for transfer is similar to GOISECs. In general, state loans are much less liquid than GOISECs. Public Sector Undertaking Bonds (PSU Bonds) : These are long term debt instruments issued by Public Sector Undertakings (PSUs). Typically, they have maturities ranging between 5-10 years and they are issued in denominations (face value) of Rs1000 each. Most of these issues are made on a private placement basis to a targeted investor base at market determined interest rates. Often, investment bankers are roped in as arrangers for these issues. These PSU bonds are transferable by endorsement and delivery and no tax is deductible at source on the interest coupons payable to the investor (TDS exempt). In addition, from time to time, the Ministry of Finance has granted certain PSUs, an approval to issue limited quantum of tax-free bonds ie bonds for which the payment of interest is tax exempt in the hands of the investor. This feature was introduced with the purpose of lowering the interest cost for PSUs which were engaged in businesses which could not afford to pay market determined rates of interest eg Konkan Railway Corporation was allowed to issue substantial quantum of tax free bonds. Thus we have taxable coupon PSU bonds and tax free coupon PSU bonds. Bonds of Public Financial Institutions (PFIs) : Apart from public sector undertakings, Financial Institutions are also allowed to issue bonds, that too in much higher quantum. They issue bonds in 2 ways through public issues targeted at retail investors and trusts and also through private placements to large institutional investors. Usually, transfers of the former type of bonds are exempt from stamp duty while only part of the bonds issued privately has this facility. On an incremental basis, bonds of PFIs are second only to GOISECs in value of issuance. PFIs have also been offering bonds with different features to meet differing needs of investors eg monthly return bonds (which pay monthly coupons), cumulative interest bonds, step up coupon bonds etc
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Corporate debentures: These are long-term debt instruments issued by private sector companies. These are issued in denominations as low as Rs 1000 and have maturities ranging between one and ten years. Long maturity debentures are rarely issued, as investors are not comfortable with such maturities. Generally, debentures are less liquid as compared to PSU bonds and the liquidity is inversely proportional to the residual maturity. A key feature that distinguishes debentures from bonds is the stamp duty payment. Debenture stamp duty is a state subject and the quantum of incidence varies from state to state
As a part of the project, the visit to the different commercial banks was made. The visits involved:
Gaining access to the banks data on investments in fixed income earning securities and application of the concepts studied on a representative sample of investment instruments. The application by the banks of the norms and policies suggested by the RBI regarding the investment portfolio of the banks. Providing summary of the banks investment in different instruments, categories, coupon rates and maturity buckets. Analysis of the investment policy, comparison with the basic benchmark ingredients of the investment policies and the coverage of the critical issues in the investment policy. Application the decision making tools used by the banks for making investments in the instruments and the factors affecting the decision making. The incorporation of the investment risk management strategies by the bank, tools / techniques used, the analysis of the guidelines prescribed in the investment policy for risk management, the exposure of the bank to the different risks, acceptance level of the risks, and the measures needed to mitigate the undesirable risks. The role of the banks investment committee and the authority and responsibility assigned to of the investment committee members. Deriving reasons for the increased preference for SLR investments by the banks. Deriving conclusions based on the analysis done and providing suggestions for the incorporation of tools and strategies wherever applicable.
Methodology followed:
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Application of the concepts on investments from different categories. Discussions with the investment officials. Getting the questionnaire filled from investment officials (copy enclosed in the annexures) A study of the investment policy, investment documents and details of the transaction in the past years. The details of the investment policies of different banks are compared in separate chapter. Paying visit to the head office, investment department, and the trading room of the banks.
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Decision making tools and factors affecting decision making. The bank has an investment committee which meets everyday in the morning to discuss the position of investments, to make any sale in the secondary market, to subscribe to any primary issues of SLR/nonSLR securities, to assess the funds position with the bank, quantum of the issue to be subscribed, the bidding amount, the number of bids to be quoted,etc. The bank does not use many investment decision making tools , but in some cases it does the duration analysis for the securities purchased and for the entire portfolio, so as determine the volatility of the security and the portfolio. Such calculations and their implications have been shown in the exhibits.
A QUICK REFLECTION
1. About 21% of t he total invest ment is i n publi c sector bonds whi ch has very high liqui di ty risk. More t han 63% of t he t ot al face value i s invest ed in securit ies havi ng interest rat e risk. About 81% of t he port folio has a coupon rate above 4%. Thi s clearly indicat es the coupon preference of the bank. About 15% of the port folio in t erms of face value i s i nvested in long mat urit y low coupon securiti es which exposes the bank t o higher i nt erest rate risk. This i s t o an extent balanced by t he banks i nvest ment in hi gh coupon securi ti es to the extent of 81% as indicat ed earlier. The modi fi ed durati on of the CG and SG port foli o (combi ned) works out t o 3. 9957. This means that one percent change in the yi eld wi ll cause approxi mat ely 3. 9957% change in t he value of t he port folio.
2.
3.
4.
5.
oriental bank's investmetns in different categories (figures in crores) Available for sale category Non - SLR investments particulars debentures others tax-free PSU bonds taxable PSU bonds shares total
face value original cost book value market value 475.00 474.84 474.84 501.95 380.49 373.76 399.22 404.31 630.57 598.27 598.27 633.63 1532.11 1530.89 1530.89 1663.31 21.28 43.65 28.41 23.84 3039.45 3021.41 3031.63 9092.49
P a tte rn o f N O N - S L R in v e stm e n ts i n th e a v a i la b l e fo r sa le c a te g o ry ( b o o k v a l u e )
d e b e n tu r e s
sh a re s 1%
d e b e n tu r e 16%
o th e rs 13%
o th e r s
ta x a b l e P S U bonds 50%
tax ab le PSU b o n d s
s h ar e s
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SLR investments central govt. securities state govt. securities trustee securities total
face value
original cost book value market value 2954.6 1391.17 498.92 4844.69 2929.45 1383.82 494.54 4807.81 3099.59 1516.55 542.45 5158.59
Held To Maturity category particualrs compensation bonds debentures tax-free PSU bonds taxable PSU bonds recapitlisation bonds shares special bonds total face value original cost book value 4.28 4.28 4.28 608.48 608.2 608.2 302 302.58 301.66 391.2 390.08 390.08 50 50 50 131.71 131.71 130.66 76.9 76.9 76.9 1564.57 1563.75 1561.78
Pattern of Non SLR investments in Held To maturity category shares 8% compensation special bonds 5% bonds 0% debentures 40% compensation bonds debentures recapitlisation bonds 3% taxable PSU bonds 25% tax-free PSU bonds taxable PSU bonds recapitlisation bonds tax-free PSU bonds 19% shares special bonds
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SLR investments particulars central Govt. securities state Govt. securities face value original cost book value 2654.2 2761.43 2752.35 133.78 133.69 133.69
Maturity and coupon buckets for the entire portfolio as on 30./09/2000 (face value) coupon buckets 0%-9% maturity buckets less than 1 year 1-3 years 3-5 years 5-10 years above 10 years total 139155750 117500000 1329900000 872825000 426536400 2885917150 2737900000 5002496000 4208000000 4545800000 3651584500 20145780500 3506036096 6893482000 20686740714 42549661286 24000110000 97636030196 6383091846 12013478000 26224640714 47968286286 28078230900 9%-11% above 11% total
10 0% 9% 0 8% 0 7% 0 6% 0 5% 0 4% 0 3% 0 2% 0 1% 0 0 %
a o 1 ye rs b ve 0 a 5 0 ye rs -1 a 3 ye rs -5 a
1 1
2 2
5 5
1 ye rs -3 aabove le th n 1 ye r ss a a
11%
3 4 53 maturity buckets
9%-11% 0%-9%
Sensitivity analysis showing the different yields under different reinvestment rates
10%
11%
12%
13%
14%
11.7152%
11.8422%
11.9755%
12.1092%
12.2454%
11.9382%
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6.75% GOI 2006 YTM = 12.03% 7% GOI 2009 YTM =12.04 7.5% GOI 2010 YTM =12.13% 8.75% GOI 2010 YTM= 12.3502% 9.5% GOI 2004 YTM=11.6752% 10.80% GOI 2008 YTM= 11.94 34% 11.10% GOI 2003 YTM= 11.344%
trend line showing the change in the YTM's for given change in the reinvestment rates for the 9.5% GOVT. security
yield to maturity
reinvestment rates
14%
12%
trend line showing the change in YTM's for given change in the reinvestment rates for the 8.75% GOVT security 13.50% yield to maturity 13.00% 12.50% 12.00% 11.50% 11.00% 10.50% 1 reinvestment rates 11.48% 11.84% 12.21% 13.00% 12.60%
The data pertains to central govt. securities as on 30/3/2000 and securities lying in varying maturity and coupon rate buckets have been selected. The coupon on the securities are paid semi annually and the YTMs have been calculated taking the market price as on the last coupon date . The final payment includes the half yearly coupon and the redemption face value of the bond. The approximate YTM has been calculated by dividing the discount on the market price of the security over the remaining maturity period of the security. The actual YTM is the internal rate of return that discounts the future cash flows to equate it to the current market price. It prevails at the date which Is used to take the market price of the security and is dynamic and changes constantly Since the coupons are half yearly, the half year YTM is calculated which is annualized by multiplying the half yearly YTM with 2.
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Current yield is a simplistic measure to show the indicative yield on a security and is useful for securities with short term to maturity and being quoted closer to the face value. It is calculated as Current yield = annual coupon rate of interest / current market price
The YTM of a security has some in built limitation which can be enumerated as: 1. It assumes that the security would be held till maturity by the investor. 2. It assumes that the coupons on the bonds would be reinvested at the YTM of the bond To remove such problems from the analysis of fixed income earning securities certain measures have been incorporated which are: 1. Yield to call (YTC) : as explained earlier, the YTC calculates the YTM of a security taking a different holding periods of the security by the investor. Bonds wuth embedded call and put options shall be analysed on the basis of YTC. 2. Effective / horizon yield: It calculates the YTM of the security taking a particular reinvestment rate till the horizon period of the assumption or till the maturity of the bond. The analysis here involves taking different reinvestment rateds for each individual security till the maturity of the security. It involves scenario building/ Sensitivity analysis which shows the change in the YTM of the security given the change in the reinvestment rate. The coupons are assumed to be reinvested at 5%,6%,7%,8%,9% half yearly i.e 10%,11%,12%,13%,14% per annum. To prove that the YTM assumes that the coupons on the securities are reinvested at the YTM of the security, analysis also involves the assumption of the coupons being reinvested at the YTM of the security and the effective yield turned out to be equal to the YTM of the security. The sensitivity analysis shows that there exists a linear relationship between the reinvestment rates nd the YTMs of the securities. This can also be seen
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from the linear trend lines which are shown in the graphs of the 9.5% GOI stock and the 8.5% GOI stock.
Sensitivity analysis showing the different yields under different reinvestment rates
10%
11%
12%
13%
14%
6.5%GOI 2004 YTM =11.97% 6.75% GOI 2006 YTM = 12.03% 7% GOI 2009 YTM =12.04 7.5% GOI 2010 YTM =12.13%
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8.75% GOI 2010 YTM= 12.3502% 9.5% GOI 2004 YTM=11.6752% 10.80% GOI 2008 YTM= 11.94 34% 11.10% GOI 2003 YTM= 11.344%
trend line showing the change in the YTM's for given change in the reinvestment rates for the 9.5% GOVT. security
yield to maturity
12.08% 11.90% 11.73% 11.56% trend line 11.39% 11% 13% 14%
reinvestment rates
trend line showing the change in YTM's for given change in the reinvestment rates for the 8.75% GOVT security 13.50% yield to maturity 13.00% 12.50% 12.00% 11.50% 11.00% 10.50% 1 reinvestment rates 11.48% 11.84% 12.21% 13.00% 12.60%
12%
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The data pertains to central govt. securities as on 30/3/2000 and securities lying in varying maturity and coupon rate buckets have been selected. The coupon on the securities are paid semi annually and the YTMs have been calculated taking the market price as on the last coupon date . The final payment includes the half yearly coupon and the redemption face value of the bond. The approximate YTM has been calculated by dividing the discount on the market price of the security over the remaining maturity period of the security. The actual YTM is the internal rate of return that discounts the future cash flows to equate it to the current market price. It prevails at the date which Is used to take the market price of the security and is dynamic and changes constantly Since the coupons are half yearly, the half year YTM is calculated which is annualized by multiplying the half yearly YTM with 2. Current yield is a simplistic measure to show the indicative yield on a security and is useful for securities with short term to maturity and being quoted closer to the face value. It is calculated as Current yield = annual coupon rate of interest / current market price
The YTM of a security has some in built limitation which can be enumerated as: 1. It assumes that the security would be held till maturity by the investor. 2. It assumes that the coupons on the bonds would be reinvested at the YTM of the bond To remove such problems from the analysis of fixed income earning securities certain measures have been incorporated which are:
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1. Yield to call (YTC) : as explained earlier, the YTC calculates the YTM of a security taking a different holding periods of the security by the investor. Bonds wuth embedded call and put options shall be analysed on the basis of YTC. 2. Effective / horizon yield: It calculates the YTM of the security taking a particular reinvestment rate till the horizon period of the assumption or till the maturity of the bond. The analysis here involves taking different reinvestment rateds for each individual security till the maturity of the security. It involves scenario building/ Sensitivity analysis which shows the change in the YTM of the security given the change in the reinvestment rate. The coupons are assumed to be reinvested at 5%,6%,7%,8%,9% half yearly i.e 10%,11%,12%,13%,14% per annum. To prove that the YTM assumes that the coupons on the securities are reinvested at the YTM of the security, analysis also involves the assumption of the coupons being reinvested at the YTM of the security and the effective yield turned out to be equal to the YTM of the security. The sensitivity analysis shows that there exists a linear relationship between the reinvestment rates nd the YTMs of the securities. This can also be seen from the linear trend lines which are shown in the graphs of the 9.5% GOI stock and the 8.5% GOI stock.
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Percentage piece change using modified duration and convexity analysis of the 2009 GOI stock (YTM as on last coupon date=12%)
Required yield Change (in basis points) Estimated % change due to Duration (1) Estimated % price change due to convexity (2) Total % change due to duration and convexity (1+2)
11.99% 1 0.06%
11.9% 10 0.64%
11.5% 50 3.2%
9% 300 19.2%
0% 0.06%
0.002% 0.642%
0.0651% 3.26%
0.26% 6.66%
1.042% 13.84%
2.346% 21.546%
Table1
Required yield Change (in basis points) Estimated % change due to Duration (1) Estimated % price change due to convexity (2) Total % change due to duration and convexity (1+2)
12.01% 1 -0.06%
12.10% 10 -0.64%
12.50% 50 -3.2%
0% -0.06%
0.002% -0.638%
0.0651% -3.13%
0.26% -6.14%
1.042% -11.75%
2.346% -16.854%
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Table 2.
price rate relationship showing the increase in price for given decrease in the yield(table 1) 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% -5.00% change in the yield
price rate relationship showing the change in price for given change Log. (price rate relationship showing the change in price for given change
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0% 0.06%
0.002% 0.642%
0.0651% 3.26%
0.26% 6.66%
1.042% 13.84%
2.346% 21.546%
convexity analysis of the 2009 GOI stock (YTM as on last coupon date=12%)
0% -0.06%
0.002% -0.638%
0.0651% -3.13%
0.26% -6.14%
1.042% -11.75%
2.346% -16.854%
Table1
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Table 2. price rate relationship showing the increase in price for given decrease in the yield(table 1) 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% -5.00% change in the yield
price rate relationship showing the change in price for given change Log. (price rate relationship showing the change in price for given change
Notes on duration and the covextiy analysis of the 7% 2009 GOI security held by OBC
The duration and the convexity have been calculated using the methods shown in the investment mathematics and concepts For a small change in the yield, Macaulays duration/modified duration does a good job in estimating the actual % price change. For larger changes in the yield, the approximation would not work because the built in convexity characteristic of a fixed income security. p Actual price depicted through convexity (p) 65
p* Tangent line (duration price) Yield Price /yield curve with tangent line
The tangent line represents the rupee duration of the bond and is used to estimate what the new price would be if the yield changes by a small measure. The % price change due to duration is less than actual % price change when yields decrease, but greater when yields increase. This means that the estimated price change due to duration would always be less than the actual price. This can be seen as the tangent line is always below the convex price yield relationship line The modified duration of the bond is 6.40 which indicates the bond price volatility i.e the bond with modified duration of 6.4 would change in price by 6.4% for 100 basis points change in the yield. This can also be verified through the rupee duration which is Rs 4.55 for 100 basis points change in this case i.e 6.4% of market price of 71.10.This is an approximate measure which takes into account the bond price change due to duration only. The bond price volatility due to convexity of the bond can be seen through the % price change incorporating the modified convexity. The modified convexity is 52.1367, which would help in deriving the % price change which turns out to be 0.26% for 100 basis points change in the yield. The change in the price of a bond for a given change in the yield can be best analysed through the combined analyses of price change due to duration and the price change due to convexity. This analysis is shown in the exhibit. As we can see from the table, duration acts as a good measure for small changes in the yields but for larger changes, convexity of the bond is to be taken into consideration. Price change due to duration shows a linear relationship with the changes in the yield which can be seen as the tangent line in the graph as well as in the table. For different changes in the yield, the price change due to duration increases or decreases in linear relation. Price change due to convexity shows a non- linear relationship with the change in the yield. The effect of convexity would lead to the situation whereby, the increase in the price of the bond for a given % decrease in the yield is greater than the decrease in the price of the bond for the same % increase in the yield. This can be seen in the table where for same changes in the basis points, the % increases in price are 0.06%, .642%, 3.26%, 6.66%, 13.84%, 21.56% and decreases in price are .06%, 0.638%, 3.13%, 6.14%, 11.75%, 16.854%. the effect fo convexity can be seen in the larger basis point changes.
Having derived the volatility through convexity of the security, the bank can mitigate the interest rate risk by hedging its position using convexity analysis. The use of hedging and convexity as a risk management tool is shown with the help of the following example.
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0 1 Interest rates
bond's conv ity iddle line) ex (m hedge 2 conv ity ex hedge 1 conv ity ex
If the hedge could be implemented by short selling hedge vehicle two(top most line), the net position will show a gain regardless of the direction of the interest rate movement. In Figure 2 , the upper curve indicates the relationship between the rate change and gains to the net position by hedging with instrument. If the hedge is implemented with the hedge vehicle 1(lowest line), a loss will be incurred regardless of the direction of the change in rates. This results from the net negative convexity in the portfolio. In Figure , the lower curve shows the relationship between rates and the loss incurred by hedging with vehicle two. This shows that better the convexity, the better it is for the bond as under both the conditions(rising and falling yields), the bond with higher positive convexity would gain more(or lose less). Hence hedge vehicle 2, which has higher convexity than the bonds convexity, should be implemented.
Figure2.
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gain or loss
The visit to the Punjab national bank presented a different picture as to how the bank used trading portfolio as a major source of income for the entire investment portfolio. Position of the banks portfolio is shown in the exhibits. The following points deserve a mention:
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The operations in the dealing room can be shown in the form of a flow chart as in the exhibit.
Mumbai office
Executes the transaction in the Back office SGL account. Maintains records of the transactions
However, holding period yield also can be used to determine the realized return from the investment. Yh=Yo + Tr(Y0-Ym) Th Where yh = holding period yield; yo = the original yield on the security acquired; ym = the yield on the security at the end of the holding period; Tr = the remaining maturity on the security at the end of the holding period and Th = the time the security is held in the investors portfolio.
Decision making tools and techniques used by bank: The executives use sophisticated computer software, which helps them to derive the YTM of the security given the market price and vice versa.
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The software helps in plotting the yield curve of securities having similar features but varying term to maturity. The yield curve analysis helps in finding out the mispriced securities amongst the various securities available. This has been shown in the exhibit. The riding the yield curve approach is also used for deriving more than the coupon returns on the security, whereby securities with maturity more than the expected holding period of the investor are bought with the expectation that the interest rate structure would not shift. With an upward sloping yield curve, the securities would be sold at the end of the holding period, with the yield on the security having come down to be compatible with the yields on securities with similar term to maturity. With the decline in the yields at the time of sale, the investor would have made capital gains because he had captured the high interest rates earlier and the market price on the security would have increased as the market interest rate at the end of the holding period is lower than the coupon rate on the security. The application of riding the yield curve concept has been shown along with the yield curve analysis in the chapter. The bank also depends upon interest rate forecasting while decision making about the securities and their maturity profile. When the interest rates are high are expected to plummet down, investments are normally made so as to capture the high interest rates and make capital gains on the asale of the securities when the interest rates fall. However, if the interest rates are expected to rise, the maturity profile of the securities is kept relatively short and in liquid securities, so as to avoid capital losses in falling interest ates situation. Also, the short term securities vary less in price than long term securities for a given change in the yields Hence, the bank can easily dispose off the liquid securities, without suffering substantial capital losses, as soon as the interest rates fall. As the bank is more into trading of securities, it does not normally depend upon the maturity structuring, duration and convexity analysis because for active trading, the market factors play far important role than in the inherent characteristics of the bonds. However, for bonds in the longer end of the maturity spectrum, the bank does calculate the duration of the bond and the entire portfolio so as to be within the acceptable limits of duration as prescribed in the investment policy. Last but not the least, the bankers use their experience in buying, transferring and disposing securities in the investment portfolio. Apart from the technical analysis, the decision making ability based on gut-feeling and subjective estimates also is a major factor behind the bank trading actively and successfully in the market and arguably being the market mover.
The application of the yield curve analysis to find mispriced securities and to find an indication of future direction of the interest rates has been shown later in the exhibits.
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The investment analyst does a sensitivity analysis to find out the change in price of securities for changes in yield. This is done by dividing the securities in different classes based on their maturity, coupon rates, YTM, duration,etc. Then the volatility of each category as a whole is looked upon under different scenarios. The analyst does not normally depend upon hedging positions by using instruments such as forward contracts, interest rate futures, options, Swaps and other derivative products. The bank has to look into Asset liability management to look for gaps in different maturity buckets of assets and liabilities and look for the interest rate sensitive gap i.e Rate sensitive gap =rate sensitive assets (RSA) rate sensitive labilities(RSL) The gap in the maturity patterns would mean that the bank runs a liquidity risk if the liabilities maturing in a particular maturity bucket are greater than the asset maturing in that bucket. On the other hand, if the bank has rate sensitive gap, then the bank runs interest rate risk as the changes in the interest rate would affect the liabilities greater than the assets or vice versa. The bank also uses extrapolation of the past trends so as to foresee any changes in the interest rate scenario and provide for that.
As the bank actively trades in the market, it has to depend upon the yield curve analysis for decision-making.
Requirements for yield curve analysis : Yield curve analysis helps the bank investment analyst to find mispriced securities amongst a range of securities having similar features as to issuer, credit risk involved, mode of periodic returns and principal repayment. But the securities differ in their term to maturity Hence, the yield curve can be plotted for dated govt. securities, short term treasury bills, corporate/PSU bonds, zero coupon/deep discount bonds, etc. But one essential requirement is that the type of security must have
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adequate number of issue maturing in different term to maturities so as to plot a representative yield curve. Also, the securities must have an adequate secondary market providing liquidity to the securities and providing bid and ask quotes for most of the securities. Such features are normally found in dated govt. securities and the treasury bills are they have many issues in different maturities and also they have active secondary market for their issues as well.
A yield curve is not stagnant and changes with the interest rate structure prevailing and depends upon the investors expectations. Hence yield curve is plotted as on a particular moment/day depending upon the above-mentioned factors. The interpertaion of the yield curve helps the analyst in 1. Determining the interest rate structure 2. Finding mispriced securities
Interpretation of the shift: The analyst expectations of future interest rate structure would also depend upon the shifts in the yield curves that have taken place in the recent past. Such shifts would indicate the macro economic direction of the movement of the interest rates. An upward shift in the yield curve would mean increase in the yields in the securities in all the maturity segments, hence indicating an overall
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increase in the interest rates. Conversely, fall in the interest rates would indicate an overall fall in the interest rate structure. The analyst behaviour due to depiction of the interest rates through shifts would remain similar to that in the case of analysis of the slope. As we can see that the exhibit shows a declining interest rate structure because there has been a fall in the yields on GOI securities having different terms to maturity. There has been a gradual downward shift in the yield curves over the last four months.
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A security above the trend line would depict that this security offers YTM, which is higher than the YTMs that the securities with similar features and term to maturity offer. Hence this security offers an attractive investment opportunity because the analyst would expect correction (reduction) in the YTM of the security, which would make this security comparable in YTM with securities of similar term to maturity. This correction would be possible as this security offers a higher YTM, which would increase the demand for the security in the market. Such increase in demand would push up the price of the security and reduce the YTM. Such reduction would continue as long as the security is above the trend line and stop as and when it is comparable with other securities along the trend line. Hence, an investor who bought the security at a higher YTM would make a capital gain because of the correction in the YTM (increase in market price). What is required is alacrity on the part of the bank investment analyst to spot such securities before market does. We can see such underpriced securities in the yield curve based on data pertaining to GOI securities. The securities which have YTM above the trend line i.e they are underpriced, they have been shown with a symbol . One such security can be seen in the graph having term to maturity of 45 months and offering YTM of 11.006%. whereas a security in the similar maturity class offers a YTM of 10.876% and is along the trend line. A security below the trend line would indicate that it is overpriced, as its YTM is lower than the YTMs of the securities with similar features and maturity. It is the security that the investment analyst would normally stay away from because a correction (increase) in the market would increase theYTM of this security to make it comparable to securities in the same class. This correction would be possible because the demand for such security would not be in the market (as similar securities are offering YTM higher than this security) which would reduce its market price and increase its YTM. The fall in the market price would be to the extent that this security follows the trend line. We can see such overpriced securities in the graph plotted. The securities have YTM below the trend line, which shows that they are overpriced. Such securities have been given a symbol . We can see one such security in the graph offering YTM of 11.33% having term to maturity of 85 months. Whereas, securities in the same maturity segment offer YTMs of 11.44-45%.
Riding the yield curve approach: application using the holding period yield.
The bank frequently uses the riding the yield curve approach and the application can be shown with the help of the following example taking the holding period yield as the yield measure. Suppose that the yield on the three and six month bills are 5 and 6 percent respectively and also assume that the bank has an expected holding period of three months. The bank could commit his funds to the three-month bill hold it until maturity and earn a return of 5 percent.
As another alternative, the bank could ride the yield curve and commit its funds to the longer term bill. In this case its return would not be known at the time of the purchase of the bill while the original yield on the bill is 6 percent the holding period return could be above or below that number depending on the price at
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which it sold the bill. For example if the structure of yields did not change during the three month period then the return to the bank would be higher than 6 percent and indeed would be 7 percent as opposed to a 5 percent holding period yield if the funds had been committed to the three month bill. The bank in this instance would benefit through riding the yield curve in two ways
It would obtain the higher yield of 6 percent through reaching for a longer maturity and it would obtain an additional bonus in yield due to the price appreciation of the security associated with the decline in yield as the bill approached maturity even if the yield structure had shifted upward riding the curve could still produce extra returns as long as the three month bill did not exceed 7 percent at the time of maturity
The concept of immunization works on the simple principal of equating the bond portfolio duration to the individual durations of the bonds.To do so, we must understand the concept of the duration of a portfolio of bonds that has inidentical duration. The duration of a portfolio of bonds is the weighted average of the duration of the individual bonds in the portfolio. For example, let duration of two bonds be 4 years and 8 years. Assume that one fourth the fund is invested in the bond with 4 years duration and the remaining in the second bond. Then duration of the portfolio is given as 1/4x4+3/4x8, which equals 7 years.
Consider a situation where a portfolio manager has only cash outflow to make from his portfolio an amount equal to Rs. 10,00,000 to be paid after 2 years. As there is only one cash outflow, its duration is 2 years. Let the portfolio manager have two choices a bond that matures after 1 year and that matures after 3 years. The manager can invest all his funds in one year bond. He can invest the process of the bond received after 1 year in a bond that has a one year maturity. In doing so, he faces reinvestment rate risk. If the interest rates were to decline after 1 year, the funds realized from the first bond have to be reinvested at lower rates of interest. Alternately, the funds manager can invest in three year bonds and sell them at market price after 2 years. The manager in this case faces the interest rate risk. If interest rates were to go up at the time of selling the bond, its price would fall. As the two risks are caused by interest rate movements in opposite directions, it would be possible to construct a portfolio of these two bonds in such a way that the affects are nullified. This process is called immunization. It is achieved by constructing the portfolio in such that its duration is equal to 2 years. Let cash flows for one year and three year bonds be as follows. There is a single cash inflow of Rs. 1,070 at the end of 1 year in case of a one-year bond. In case of a three year bond, there are annual payments of Rs. 80 for 3 years and a payment of Rs.1,000 at the end of 3 years. The duration of one year bond, which
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is like a ZCB,is 1 year. The duration of three year bond can be calculated to be 2.78 years. We have to now find the proportion of investment to be made in these two bonds. If W1 and W2 are proportions invested in one-year and three year bonds, then: W1 + W2 = 1 W1 x 1 + W2 x 2.78 = 2 The first equation states that sum of weights is 1. The second equation stipulates that the duration of the portfolio is 2 years. We can get the percentage investments in the two bonds by solving the above two equations. From the first equation we can get W1 to be equal to 1-W2. Substituting this value of W1 to be equal to 1-W2. Substituting this value of W1 in the second equation we get: 1-W2+2.78 x W2 = 2 1.78W2 = 1 W2 = 1/1.78=0.5618 Substituting this value of W2 in first equation, we get: W1 = 1 - 0.5618 = 0.4383 For immunization, the portfolio manager has to invest 56.18% in three year bond and 43.82% in one year bond. The amount to be invested today to get a cash flow of Rs. 10,00,000 after 2 years, assuming a YTM of 10% is given as 10,00,000/1.12, which would be Rs. 8,26,446. Using the percentages worked out above, one can calculate the investment into one year and three year bonds to be Rs. 3,62,149 (8,26,446 x 0.4382)and Rs/ 4,64,297 (8,26,446 x 0.5618) respectively. At 10% YTM, the prices of one year and three years bonds can be worked out to be Rs. 972.73 and Rs. 950.25.At these prices, the number of one-year and three year bonds purchased would be 372 (3,62,149/972.73) and 489 (4,64,297/950.25). The bonds invested in this ratio would counterbalance each others interest rate risk to eventually nullify it. Hence, any movement in the interest rates would affect only the individual bonds value but not affect the entire bank investment portfolios value.
Trading Risk Management: Stop-Loss (Or Cut-Loss) Limits Stop- loss li mi ts are risk cont rol mechani sms. A stop-loss i s the maxi mum permi ssi ble loss t hat can be i ncurred by a dealer/t rader on a si ngle posit ion or a port foli o of posit ions. It is t he poi nt at whi ch ei ther approval of a superior aut hori ty is requi red t o conti nue wit h the posit ion (popularly called as Management acti on tri gger (MAT) in advanced market s) or the t rader has to square off t he posit ion and book t he loss. For a short -term port foli o like the t rading port foli o, i t is essenti al to have the stop-loss li mit s. The simplest t ype of stop-loss limit i s the one, whi ch is est abli shed at i ndi vi dual securi ty level in the t radi ng port foli o. To i llustrat e, i f t he stop-loss limit for a securit y is 10% and t he securit y was purchased by the bank at Rs. 110/- t hen t he stop-loss will be
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t ri ggered when the securi tys pri ce falls to Rs. 99/ - (i .e., 10% of Rs. 111) or below. At t hi s level the enti re holdi ng of t he securit y in questi on has to be sold and the posit ion has t o be squared off. If t he pri ce of t he securi ty goes up to Rs. 120/- t hen the stop-loss limit will aut omat ically trai l t he pri ce of t he securi ty and t he new st op-loss wi ll be at Rs. 108/- (i. e., 10% of Rs. 120). Thi s is called as trail ing stop-l oss l imi t, t he st op-loss limit would not be and should not be adjusted when the securit ies price falls. It i s to be carefully not ed that upward recession in the st op-loss if implemented in this manner wi ll ensure t hat t here trader i s not only able t o limit the losses but also lock i n profi ts. It i s recommended that the invest ment poli cy should have clear guideli nes on the fi xi ng the stop-loss li mit s securi ty-wi se. The st op loss limit can also be prescri bed at port folio level. For example if t he loss at port foli o level exceeds Rs. 3 lakhs per month, t hen the stop-loss wi ll be t ri ggered and t he posi ti on would eit her be closed out. It i s felt t hat t o start wit h securit y-wise t railing stop-loss li mit s can be used by t he bank t o li mi t the extent of losses in t he t rading port foli o. As the bank gai ns suffi cient experience i n usi ng i t, t hen port foli o level st op-loss li mit s can be t hought of. Dependi ng on t he volat ilit y of t he securi ty and the nat ure of t he market for the securit y i n questi on t he li mit s will vary.
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Notes To The Maturity Structure And Instruments Of Investments: Normally the bank does not depend upon the securities in the longer end of the maturity bucket as a source of income generation. Rather, it actively trades in securities to make gains. This can be seen in the maturity profile of the investments as their has been reduction in the amount of investments in the above 10 years category and increase in the more liquid 5-10 years and 1-5 years categories. The investments in the below one year liquid portfolio have also increased. These changes show the banks preference for trading activities. The overall investment portfolio of the bank has increased by roughly 3300 cores and the increase can be seen in the investments in all SLR instruments except state Govt. securities which have seen a significant decline of 4000 crores. The major increase has been seen in investments in the trustee securities to the extent of 4400 crores. Hence, in a way, the state investments have moved towards trustee securities investments. The non SLR investments increased form 4108 crores in the last to 4923 crores in the current year. The investments been dominated by investments in the taxable and taxfree PSU bonds which have seen an increase in investments over the last year. Though the certificate of deposits and commercial papers dont figure in the investment position, but the bank invests in them for short maturity periods and also trades in the commercial papers. As on the balance sheet date, there are no outstanding positions in these instruments. The modified duration of the entire investment portfolio was 4.78 as on 31 march 2001. This indicates that if the yield increases by 100 basis points, the market price of the portfolio would decrease by 4.78% and vice versa.
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The visit to Punjab and Sind bank concludes the series of visit to the banks. The details of the bank visit are as under:
Investment scenario
The investment activity at PSB was found to be active.. The bank is a major participant in the Indian debt and money market. The investment portfolio is quite diversified with investments in most of the investment avenues. The summary of the banks investments has been shown in the exhibits which shows the banks investments in different maturity and coupon buckets. The bank has an investment committee, which constitutes of the chairman & managing director (CMD), the executive director (ED) and the general manager (GM). They are responsible for decision-making and have been given due powers and authority to do so. The bank has an elaborate investment policy to provide direction to the activities of the investment department..
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2.
Suggestion for investment risk management: The bank has not incorporated any major investment risk management tool. Therefore, the bank should use the value at risk framework to determine the portfolio risk for a given change in yield and for a given tolerance level. The application has been shown in the exhibits. Break-even reinvestment rate It is the rate at which the effective yields for two bonds over a given horizon are equal. Depending on the two bonds maturities, coupons and prices, the effective yield of one of the bonds is expected to be greater than that of the other if the reinvestment rate is below the break-even rate, and smaller if it is above the break even rate. Therefore, depending on the expectation of where interest rates are likely to be, it is possible to conclude whether one bond is relatively more attractive than another.
Figure compares Bond 1, a five-year 15% bond that is priced at 120, and Bond 2, a five year 5% bond that is priced at 80, for a horizon of five years (the same as the maturity of the bonds). The effective yields for the bonds at various reinvestment rates from 8% to 16% are shown. Bond 2 will have a greater effective yield if 8% reinvestment rate is assumed. On the other hand, if a 16% reinvestment rate is assumed, Bond I would have a higher effective yield. Both bonds have higher returns as reinvestment-rate assumption climb, yet they do not increase at the same rate. Figure shows a graph of this
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relationship, which is a sloping curve for each bond, but the curve for Bond 1 is steeper.
Bond 1 Bond 2 Type of instrument Dated GOI security Dated GOI security Coupon 15% 5% Maturity 10/1/02 10/1/02 Price Reinvestment Bond 1(yield) Bond280 120 Yield rate 9.84% (Yield)10.21% 8 9.41 9.95 9 9.64 10.07 10 9.88 10.18 11 10.12 10.3 12 10.36 10.42 13 10.61 10.55 14 10.86 10.67 15 11.12 10.8 16 11.37 10.93
FIGURE
Break Even Reinvestment Rate
Effective yield 13.5 12 10.5 9 7.5 6
8 9 10 11 12 13 14 Re inv es tm en t ra te 15
The reinvestment rate is 12.49%, which indicates that if the coupons were reinvested at this rate then the effective yield from both the bonds would converge.
Figure illustrates this point at which the two curves intersect. By examining the location of the break-even reinvestment rate between two bonds, the bank analyst can determine which bond is more attractive. If the analysts expectation of future rates is higher than the break-even reinvestment rate, then the 15% bond will achieved a greater effective yield than the 5% bond, as shown by Figure. Conversely, if the analysts expectation of future rates is lower than the break-even reinvestment rate, then the 5% bond will achieve a greater effective
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yield. The bank greatly benefit from such an analysis as it has to constantly depend upon the future interest rate expectations and hence proper prediction would help the bank analyst to choose the better of the two similar securities.
Bullet and dumbbell portfolio analysis: This analysis indicates the importance of convexity in a situation where yield and duration measures do not indicate the option to choose. The application can be shown with the help of analysis of three dated govt. securities ( shown in the exhibit).
Suppose the bank is considering the following two investment alternatives: invest all the funds in 9.25% GOI security 2010( C ),
Or , invest 50 % of the funds in 8.50% GOI security 2005 ( A ) and 50% in 9.50% GOI security 2020 ( B ). Thus the first portfolio consists of a bond with maturity between that of two other bonds. Hence, the first portfolio is a bullet portfolio and the second is a dumbbell portfolio. The dollar duration of the bullet is 6.434. The dollar duration of the dumbbell is simply the weighted average of the bonds A and B, where the weights are the percentages of each bond in the portfolio. As shown in the exhibit, the dollar duration of the bullet is same as that of dumbbell. Hence, taking duration as a decision making measure, one can be indifferent towards any of the portfolio as both of them appear to have same interest rate risk exposure. A comparison on the yield to maturity of the bullet to the weighted average yield to maturity of the dumbbell would be an incomplete analysis and would pose problems. Firstly, the yield to maturity of two bonds is not the weighted average yield to maturity but it is the internal rate of return of the cash flows of the two bonds. The weighted average yield to maturity of two bonds would only be an approximation of the internal rate of return of the cash flows. Secondly, the YTM is an incomplete measure as it assumes that the bond would be held till maturity and the coupons would be reinvested at the YTM of the bond, though, the reinvestment rate and the holding period of the bond depends upon the interest rates structure and investor expectations. However, continuing with the analysis if yields, the YTM of the bullet is 9.25% and the weighted average yield of the dumbbell is 9.00%. This might suggest that there is a yield pick of 25 basis points by buying the bullet instead of dumbbell. However, this might lead to wrong decision-making as the bond price performance depends not only on YTM and duration but also on the convexity of the bond. The greater the convexity of a bond, the better the price performance of the bond would be no matter whether the yields increase or decrease. The dumbbell has greater dollar convexity which means better price performance. This can be cross checked by further analysis whereby for any given change in the yield, the dumbbell would gain more( or lose less) than the bullet. Thus, the analysis shows the importance of convexity of a bond while decision-making. The bank can benefit by such an analysis for investment in longer dated bonds and use convexity analysis for bonds used for trading activities as well.
Chapter 8
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The visit to Punjab and Sind bank concludes the series of visit to the banks. The details of the bank visit are as under:
Investment scenario
The investment activity at PSB was found to be active.. The bank is a major participant in the Indian debt and money market. The investment portfolio is quite diversified with investments in most of the investment avenues. The summary of the banks investments has been shown in the exhibits which shows the banks investments in different maturity and coupon buckets. The bank has an investment committee, which constitutes of the chairman & managing director (CMD), the executive director (ED) and the general manager (GM). They are responsible for decision-making and have been given due powers and authority to do so. The bank has an elaborate investment policy to provide direction to the activities of the investment department..
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4.
Suggestion for investment risk management: The bank has not incorporated any major investment risk management tool. Therefore, the bank should use the value at risk framework to determine the portfolio risk for a given change in yield and for a given tolerance level. The application has been shown in the exhibits. Break-even reinvestment rate It is the rate at which the effective yields for two bonds over a given horizon are equal. Depending on the two bonds maturities, coupons and prices, the effective yield of one of the bonds is expected to be greater than that of the other if the reinvestment rate is below the break-even rate, and smaller if it is above the break even rate. Therefore, depending on the expectation of where interest rates are likely to be, it is possible to conclude whether one bond is relatively more attractive than another.
Figure compares Bond 1, a five-year 15% bond that is priced at 120, and Bond 2, a five year 5% bond that is priced at 80, for a horizon of five years (the same as the maturity of the bonds). The effective yields for the bonds at various reinvestment rates from 8% to 16% are shown. Bond 2 will have a greater effective yield if 8% reinvestment rate is assumed. On the other hand, if a 16% reinvestment rate is assumed, Bond I would have a higher effective yield. Both bonds have higher returns as reinvestment-rate assumption climb, yet they do not increase at the same rate. Figure shows a graph of this
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relationship, which is a sloping curve for each bond, but the curve for Bond 1 is steeper.
Bond 1 Bond 2 Type of instrument Dated GOI security Dated GOI security Coupon 15% 5% Maturity 10/1/02 10/1/02 Price Reinvestment Bond 1(yield) Bond280 120 Yield rate 9.84% (Yield)10.21% 8 9.41 9.95 9 9.64 10.07 10 9.88 10.18 11 10.12 10.3 12 10.36 10.42 13 10.61 10.55 14 10.86 10.67 15 11.12 10.8 16 11.37 10.93
FIGURE
Break Even Reinvestment Rate
Effective yield 13.5 12 10.5 9 7.5 6
8 9 10 11 12 13 14 Re inv es tm en t ra te 15
The reinvestment rate is 12.49%, which indicates that if the coupons were reinvested at this rate then the effective yield from both the bonds would converge.
Figure illustrates this point at which the two curves intersect. By examining the location of the break-even reinvestment rate between two bonds, the bank analyst can determine which bond is more attractive. If the analysts expectation of future rates is higher than the break-even reinvestment rate, then the 15% bond will achieved a greater effective yield than the 5% bond, as shown by Figure. Conversely, if the analysts expectation of future rates is lower than the break-even reinvestment rate, then the 5% bond will achieve a greater effective
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yield. The bank greatly benefit from such an analysis as it has to constantly depend upon the future interest rate expectations and hence proper prediction would help the bank analyst to choose the better of the two similar securities.
Bullet and dumbbell portfolio analysis: This analysis indicates the importance of convexity in a situation where yield and duration measures do not indicate the option to choose. The application can be shown with the help of analysis of three dated govt. securities ( shown in the exhibit).
Suppose the bank is considering the following two investment alternatives: invest all the funds in 9.25% GOI security 2010( C ),
Or , invest 50 % of the funds in 8.50% GOI security 2005 ( A ) and 50% in 9.50% GOI security 2020 ( B ). Thus the first portfolio consists of a bond with maturity between that of two other bonds. Hence, the first portfolio is a bullet portfolio and the second is a dumbbell portfolio. The dollar duration of the bullet is 6.434. The dollar duration of the dumbbell is simply the weighted average of the bonds A and B, where the weights are the percentages of each bond in the portfolio. As shown in the exhibit, the dollar duration of the bullet is same as that of dumbbell. Hence, taking duration as a decision making measure, one can be indifferent towards any of the portfolio as both of them appear to have same interest rate risk exposure. A comparison on the yield to maturity of the bullet to the weighted average yield to maturity of the dumbbell would be an incomplete analysis and would pose problems. Firstly, the yield to maturity of two bonds is not the weighted average yield to maturity but it is the internal rate of return of the cash flows of the two bonds. The weighted average yield to maturity of two bonds would only be an approximation of the internal rate of return of the cash flows. Secondly, the YTM is an incomplete measure as it assumes that the bond would be held till maturity and the coupons would be reinvested at the YTM of the bond, though, the reinvestment rate and the holding period of the bond depends upon the interest rates structure and investor expectations. However, continuing with the analysis if yields, the YTM of the bullet is 9.25% and the weighted average yield of the dumbbell is 9.00%. This might suggest that there is a yield pick of 25 basis points by buying the bullet instead of dumbbell. However, this might lead to wrong decision-making as the bond price performance depends not only on YTM and duration but also on the convexity of the bond. The greater the convexity of a bond, the better the price performance of the bond would be no matter whether the yields increase or decrease. The dumbbell has greater dollar convexity which means better price performance. This can be cross checked by further analysis whereby for any given change in the yield, the dumbbell would gain more( or lose less) than the bullet. Thus, the analysis shows the importance of convexity of a bond while decision-making. The bank can benefit by such an analysis for investment in longer dated bonds and use convexity analysis for bonds used for trading activities as well.
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The visit to Punjab and Sind bank concludes the series of visit to the banks. The details of the bank visit are as under:
Investment scenario
The investment activity at PSB was found to be active.. The bank is a major participant in the Indian debt and money market. The investment portfolio is quite diversified with investments in most of the investment avenues. The summary of the banks investments has been shown in the exhibits which shows the banks investments in different maturity and coupon buckets. The bank has an investment committee, which constitutes of the chairman & managing director (CMD), the executive director (ED) and the general manager (GM). They are responsible for decision-making and have been given due powers and authority to do so. The bank has an elaborate investment policy to provide direction to the activities of the investment department..
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2. 3. 4. 5. 6. 7.
Maturity of the portfolio and the instrument Liquidity of the portfolio and the instrument. Secondary market operations of the instrument Risk weightage for capital adequacy norms Tax deductions available on the instrument Possibility of capital appreciation, etc.
The bank uses current yield and the yield to maturity as the yield measures. The investment committee regularly meets to discuss the portfolio position and to sanction any new deals(sale/purchase). The trading room executives execute the sanction of the investment committee. Their activity is limited to execution and they do not have the authority to exercise discretion and benefit from the market opportunities as and when they arise. The investment analyst does depend upon certain tools and techniques for decision-making. 9. The bank uses duration analysis to determine the portfolio sensitivity to change in yields. 10. It uses the riding the yield curve approach the derive more than expected returns from market. 11. It depends upon the expectation of the future interest rates to decide the security to invest in. 12. It structures the portfolio maturity to reduce the duration gap and rate sensitive gap between assets and liabilities.
6.
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The bank has not incorporated any major investment risk management tool. Therefore, the bank should use the value at risk framework to determine the portfolio risk for a given change in yield and for a given tolerance level. The application has been shown in the exhibits. Break-even reinvestment rate It is the rate at which the effective yields for two bonds over a given horizon are equal. Depending on the two bonds maturities, coupons and prices, the effective yield of one of the bonds is expected to be greater than that of the other if the reinvestment rate is below the break-even rate, and smaller if it is above the break even rate. Therefore, depending on the expectation of where interest rates are likely to be, it is possible to conclude whether one bond is relatively more attractive than another.
Figure compares Bond 1, a five-year 15% bond that is priced at 120, and Bond 2, a five year 5% bond that is priced at 80, for a horizon of five years (the same as the maturity of the bonds). The effective yields for the bonds at various reinvestment rates from 8% to 16% are shown. Bond 2 will have a greater effective yield if 8% reinvestment rate is assumed. On the other hand, if a 16% reinvestment rate is assumed, Bond I would have a higher effective yield. Both bonds have higher returns as reinvestment-rate assumption climb, yet they do not increase at the same rate. Figure shows a graph of this relationship, which is a sloping curve for each bond, but the curve for Bond 1 is steeper.
Bond 1 Bond 2 Type of instrument Dated GOI security Dated GOI security Coupon 15% 5% Maturity 10/1/02 10/1/02 Price Reinvestment Bond 1(yield) Bond280 120 Yield rate 9.84% (Yield)10.21% 8 9.41 9.95 9 9.64 10.07 10 9.88 10.18 11 10.12 10.3 12 10.36 10.42 13 10.61 10.55 14 10.86 10.67 15 11.12 10.8 16 11.37 10.93
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FIGURE
Break Even Reinvestment Rate
Effective yield 13.5 12 10.5 9 7.5 6
8 9 10 11 12 13 14 Re inv es tm en t ra te 15
The reinvestment rate is 12.49%, which indicates that if the coupons were reinvested at this rate then the effective yield from both the bonds would converge.
Figure illustrates this point at which the two curves intersect. By examining the location of the break-even reinvestment rate between two bonds, the bank analyst can determine which bond is more attractive. If the analysts expectation of future rates is higher than the break-even reinvestment rate, then the 15% bond will achieved a greater effective yield than the 5% bond, as shown by Figure. Conversely, if the analysts expectation of future rates is lower than the break-even reinvestment rate, then the 5% bond will achieve a greater effective yield. The bank greatly benefit from such an analysis as it has to constantly depend upon the future interest rate expectations and hence proper prediction would help the bank analyst to choose the better of the two similar securities.
Bullet and dumbbell portfolio analysis: This analysis indicates the importance of convexity in a situation where yield and duration measures do not indicate the option to choose. The application can be shown with the help of analysis of three dated govt. securities ( shown in the exhibit).
Suppose the bank is considering the following two investment alternatives: invest all the funds in 9.25% GOI security 2010( C ),
Or , invest 50 % of the funds in 8.50% GOI security 2005 ( A ) and 50% in 9.50% GOI security 2020 ( B ). Thus the first portfolio consists of a bond with maturity between that of two other bonds. Hence, the first portfolio is a bullet portfolio and the second is a dumbbell portfolio. The dollar duration of the bullet is 6.434. The dollar duration of the dumbbell is simply the weighted average of the bonds A and B, where the weights are the percentages of each bond in the portfolio. As shown in the exhibit, the dollar duration of the bullet is same as that of dumbbell. Hence, taking duration as a decision making measure, one can be indifferent towards any of the portfolio as both of them appear to have same interest rate risk exposure.
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A comparison on the yield to maturity of the bullet to the weighted average yield to maturity of the dumbbell would be an incomplete analysis and would pose problems. Firstly, the yield to maturity of two bonds is not the weighted average yield to maturity but it is the internal rate of return of the cash flows of the two bonds. The weighted average yield to maturity of two bonds would only be an approximation of the internal rate of return of the cash flows. Secondly, the YTM is an incomplete measure as it assumes that the bond would be held till maturity and the coupons would be reinvested at the YTM of the bond, though, the reinvestment rate and the holding period of the bond depends upon the interest rates structure and investor expectations. However, continuing with the analysis if yields, the YTM of the bullet is 9.25% and the weighted average yield of the dumbbell is 9.00%. This might suggest that there is a yield pick of 25 basis points by buying the bullet instead of dumbbell. However, this might lead to wrong decision-making as the bond price performance depends not only on YTM and duration but also on the convexity of the bond. The greater the convexity of a bond, the better the price performance of the bond would be no matter whether the yields increase or decrease. The dumbbell has greater dollar convexity which means better price performance. This can be cross checked by further analysis whereby for any given change in the yield, the dumbbell would gain more( or lose less) than the bullet. Thus, the analysis shows the importance of convexity of a bond while decision-making. The bank can benefit by such an analysis for investment in longer dated bonds and use convexity analysis for bonds used for trading activities as well.
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Value at risk
loss in
Computation of Value At Risk, e.g. one ay maximum the market with 99% confidence interval
Expected value
As explained earlier, Value at risk can be defined as the worst loss that can be expected from holding a security or a portfolio for a given period of time( say a single day or 10 days). For example, in the case of above shown positon , if we say that the position has a daily VAR of Rs. 10 million at 99 % confidence interval, we mean that the realized daily losses from the position, on average, will be higher than 10 million only one day in every 100 trading days.
VAR offers a probability statement about the potential change in the value of the portfolio resulting from a change in the market factors, over a specified period of time. It offers the answer to the question teat:
What is the maximum loss over a given period such that there is a low probability, say 1 % probability that the actual loss over the given period will be higher.?
The VAR measure does not state by how much actual losses would exceed the VAR figure; it only states hiw likely or unlikely is that the VAR figure will be exceeded.
As illustrated in the figure, calculating VAR involves the following steps; 1. We need to define the distribution of returns from the security i.e distribution of the changes in the value of the security. Only then we can calculate the mean and the standard deviation of the value of the security The distribution can be derived form the historical price distribution which are assumed to have a normal distribution(bell shaped distribution showed in the figure) 2. We shall than assume the confidence level ( c )for the VAR; say if it is 99% confidence interval (1% tolerance level), then we need to calculate the first percentile of this distribution( as shown in the distribution as the left hand tail.).
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3. Here, VAR is the maximum loss at the 99% confidence level, measured in relation to the expected value of the portfolio at the target horizon ( one day in this case) 4. Value At Risk
= expected profit/loss worst case loss at the 99% level OR Value At Risk =2.33 * standard deviation(volatility)
confidence
where 2.33 represents the area under the normal distribution curve covering 99% of the area. If we change the confidence level, the value would change from 2.33 to the respective confidence level. ( such values can be seen from the Z distribution table given in the statistics books) Standard deviation represents the volatility of the particular security( or portfolio) A practical example to calculate the one day Value At Risk has been shown taking a zero coupon bond.
E.g : consider a hypothetical 10 year GOI zero coupon bond with face value of 100 crores. The volatility is brought about by the change in price triggered by change in the yield. Suppose the current YTM is 7.00% and the distribution of the volatility shows that it is normally distributed with standard deviation(s.d) of 10 basis points or 0.001% The current market price of the bond can be computed which is 100/1.0710 = Rs 50.8349 crores. Since we need to plot the distribution of the bond price rather than its yield, we can find the change in the bond price in relation to the change in the yield., based on the duration price relationship;
i.e dB = --B
D
1+y
dy
where dB is the daily volatility distribution of the change in the prce, B is current market price of the bond, D is the term to maturity of the bond, y is the current yield to maturity of the bond, dy is the daily volatility of the bond.
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* 0.001 1+0.07 = Rs 0.5031199 crores VAR (one day; 99.7% confidence level) =3.00*0.5031199=1.50938 crores. VAR( 10 days; 99.7 % confidence interval) = (10)1/2 * VAR(one day) = 3.16227* 1.50938=4.77306
= --53.8349 * 10
VAR Is For Measuring And Managing Risk. VAR is a powerful tool and has far reaching uses. VAR provides a common, consistent and integrated measure of risk across risk factors, instruments and asset classes, leading to greater risk transparency and consistent treatment of risks across the bank. For. Example, it allows the investment manager to measure the risk of a fixed income position with that inherent in a stock derivative position. Also, it takes into consideration, the correlation between various risk factors. If two risks offset each other, then VAR incorporates that and indicates that the relative risk is comparatively smaller and vice versa. VAR provides an aggregate measure of risk: a single number that is related to the maximum loss that might be incurred on a position, at a given confidence level. This single number can be easily translated into capital requirement. In other words, it cam be used to measure risk adjusted performance. The risk taken by a business line can be monitored using limits set in terms of VAR. these limits can ensure that the individuals do not take more risk than they are allowed to take. VAR also allows the bank managers to detect which unit is taking what risk and whether it is within the limits prescribed or not. VAR provides senior managers, board of directors and regulators with a risky measure which they can understand. Hence, they can put their comfort level of risk in VAR terms. VAR also provides a framework to assess the investments and projects on the basis of their risk adjusted return on capital. A VAR system allows the bank to assess the benefits of portfolio diversification not only within a line of activity but also across businesses( such as between fixed income and equity businesses.) VAR can be used as an internal and external reporting tool. VAR reports can be prepared for circulation amongst senior bank managers. It can be used in the annual reports of banks as a key risk indicator providing comfort to the shareholders.
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Chapter 9 Analysis Of The Banks Investment Scenario :Gaps In The Investment Policy And Activities
The banks visited had clear cut investment policy guidelines for the investment activities. The investment policies were quite comprehensive in: 1. Objectives of the investment policy 2. Action plan to achieve the objectives. 3. Guiding principles for the activities 4. Constitution of the investment committee 5. Activities of the investment committee 6. Powers, duties and responsibility of the investment officials. 7. Following the RBI guide lines. 8. The securities in the investment portfolio 9. Exposure limits of investment in each avenue. 10. Accounting policy and norms 11. Empanelment and guidelines for dealing with brokers 12. Back office functions ; etc.
However, the policies did not put emphasis on the important aspects of active trading in the secondary markets and incorporation of risk management tools and strategies. . Some suggestions for a comprehensive investment policy (stressing on the risk management and trading aspects ) have been given as under.
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Risk Management Aspects And Operational Guidelines The bank of International settlements states that an effective risk management process for investment portfolio management includes
Policies, procedures and li mi ts Ident ificat ions, measurement and reporti ng of Risk exposures A syst em of Internal cont rols.
The invest ment poli cy has t o provi de a basi c st ruct ure and framework wit hin whi ch t he i nvest ment port folio has to be managed effect ively. The invest ment poli cy is an essent ial part of t he overall asset li abilit y management policy of t he bank. The i nvest ment port foli o cannot be viewed i n i solati on from t he overall posi ti on of the bank i n terms of A/L mi smat ches. This i s ext remely import ant because of t he followi ng t wo confli cti ng reasons. Given the rigi di ties in t he advances and deposi ts port foli o i n the Indi an environment , t he i nvest ment port foli o is one of t he pri me sources of li qui di ty, di versi ty and flexi bi li ty which are very valuable from the poi nt of vi ew of managi ng di fferent types of risk exposures and A/L mi smat ches. In addi ti on t he i nvest ment port foli o i s i ncreasingly vi ewed as a key profit cent re i n Indian commerci al banks. Whi le the i nvest ment port folio helps i n managi ng t he risk exposures, often the i nvest ment port folio it self account s from a signi fi cant source of market and other risks which needs a closer att enti on and management .
Given the above, the investment policy should contain and address the following vital issues:
1. One of t he purposes of the poli cy i s to provide clear gui dance and risk control l imi ts for t he port folio managers of the bank. The poli cy wi ll also enable, through reporti ng standards, t he board of di rectors and the Top Management of the bank t o have bett er underst andi ng of the composi ti on and risks associ at ed wi th t he management of the i nvest ment port folio. It needs to be reali zed whi le frami ng the invest ment policy that t he invest ment port foli o act s as a central cash fl ow reposi tory and as a source of li qui di ty for t he bank to meet mismat ches arising out asset and liabi li ty di st ri but ions. There i s always a trade-off bet ween li qui dit y and return. Hence the bank must decide on t he quant um of li qui dit y t hat wi ll be requi red from t he i nvest ment port foli o, and accordi ngly, i t needs to be mai nt ai ned at di fferent poi nt s i n ti me. The policy should recogni ze the need for di versi fi cati on of t he i nvest ment port foli o on vari ous di mensi ons such as geographi c locati on, sect or, i ndust ry, t ype of securi ty, mat uri ty, coupon, credi t rat ing (i nt ernal or ext ernal), etc.
2.
3.
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4.
The basic strat egic objecti ves of managi ng the i nvest ment port folio in t he order of priori ty have t o be st at ed in explicit t erms. For example: t he strat egic object ive shall be, in t he order of pri orit y, t o a. Preserve capi tal; b. Provi de the highest total return possi ble in consi st ent wi th t he prudent level of market risk and other risks; and To mai nt ai n liqui di ty etc.
c. 5.
The bank has t o, dependi ng on the object ives, choose an appropri ate yield or return measure such as current Yi eld, YTM or total ret urn as a cri teri on for assessi ng the ret urn pot ent iali ties of securit ies. Each one of the measures ment ioned above has i ts own implicat ions for port folio const ructi on and may result i n di fferent performance under various market environment s. The basic nat ure of t he port folio wi ll be di fferent dependi ng on t he measure used. The bank t o achieve a specific purpose can also use combi nati on of the measures menti oned above.
. Often times, the current choice of the yield measure may constrain the overall return from the investment portfolio, e.g., a portfolio with the highest current yield need to necessarily ensure highest total return. Similarly, the portfolio with the highest YTM need not necessarily ensure the highest total return.
6. The object ives once i denti fi ed will determi ne whet her acti ve or passi ve investment portfoli o strat egy has t o be followed. If t he objecti ve i s t o att ai n t he highest ret urn possi ble (wi th hi gher risk tolerance) then t he st rategy to be followed is acti ve st rategy. If t he objecti ve is to earn normal ret urns, wit h t he least risk, then passive strat egies are appropriate. The i nvest ment policy should cover t hese aspect s. There should be a clear and consci ous att empt by the bank t o i denti fy, measure, moni tor periodi cal ly and control the followi ng ri sks affect ing t he invest ment port foli o. The invest ment policy document should contai n t he ways in which t he above object ive wi ll be achieved. 8. Int erest rate ri sk Yield curve risk Opt ions risk Credit or default ri sk Li qui dit y ri sk Operat ional risk
7.
The risk tolerance of the bank for each one of t he ri sks ment ioned above for t he i nvest ment port folio (or it s vari ous categori es) has t o be spelt out in clear terms in
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t he i nvest ment policy and sui table measures have to be used for t hi s purpose. example, t o li mi t the exposure to the interest rat e ri sk of t he bank in i nvest ment port folio (or segment s in t he port folio), the bank can prescri be maxi mum Modi fied Durati on t hat the port foli o or i ts segment s can have at poi nt i n ti me. The ot her measures that ca be used for t he same purpose Durat ion and PVBP.
By limit ing the modi fi ed Durat ion of the port foli o, the bank will be in a posi ti on to limit the exposure of the port foli o t o interest rat e risk. 9. There are two ways i n which the modi fi ed durati on li mi ts can be set : wit h a benchmark port folio and wit hout a benchmark port foli o
If the bank chooses to have a particular index as a benchmark portfolio (e.g., I-SEC Index for Central Govt. Securities Portfolio), then the modified duration of the benchmark portfolio (with appropriate lower and upper bounds). If no benchmark is used, then the bank has to set a modified duration limit directly. 10. Similarly, the tolerance limits for other risks also have to be set. For default risk, the tolerance can be on the basis of either external rating available or on the basis of the banks own internal credit rating. 11. To set a limit for options risk, the easiest way is to limit the quantum of securities with optionalities such as call option. Though other sophisticated measures are available and are used in advanced countries, those measures are difficult to apply at present in Indian market. 12. The yield curve risk arises as a result of non-parallel shifts in the yield curve. Since the standard duration measure assumes that the yield curve shifts are parallel, yield curve risk has to be measured in a different way. To monitor and control yield curve risk periodically, the total portfolio has to be segmented into a number of duration segments. Having segmented the portfolio, a tolerance limit has to be set for the duration of each segment. For example, assume the following duration segments: 0 4 years 4 8 years and 8 years or more
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For each one of the duration segments above, the maximum limit need to be set by the bank to effectively monitor the yield curve risk. The above duration segments are indicative in nature. Depending on the current structure of the investment portfolio of the bank, the segments have to be defined. It is worth mentioning here that as volatility of different segments change over a period, the limits for each segment has to accordingly undergo a change. 13. As pointed out elsewhere, the investment portfolio management is critical from the point of view of liquidity risk management of the entire bank. To set a ceiling on the liquidity risk of the investment portfolio, the proportion of highly liquid securities to the total portfolio has to be fixed by the bank and this proportion has to be monitored continuously. Liquidity should be one of the parameters while taking a decision to buy or sell a security. It needs to be stressed here that there is always a trade-off between liquidity and return from a security. 14. The bank should consciously choose the maturity-mix of the portfolio and the preferred maturity mix needs to be mentioned in the investment policy of the bank. This in effect provide the direction for portfolio revision. It needs to be recognized that any concentration and bunching of maturity may lead to liquidity and reinvestment risks. 15. To take care of operational risk in the investment portfolio, there should be a proper internal control mechanism in place, the front office should be separated from the back office. The current investment policy of the bank covers these aspects in detail. 16. One of the basic steps in the management of investment portfolio is measuring the performance of the portfolio periodically against a benchmark. This will throw light on whether the investment objectives are attained or not. The investment policy, as a basic document providing the framework for the investment function, would serve its basic purpose better in the long-term if the system of performance evaluation is given adequate importance.
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Although derivatives provide the added advantages in risk management, banks have to be cautious in application of these instruments. Otherwise, it may lead to problems. Traditionally built up organizations are to be suitably restructured to adopt advanced risk management strategies. Certain prerequisites are to be essentially established before banks go for derivatives usage. These are presented in this section.
Knowledge Management
Conventional banking is encircled around debit and credit transactions. Although, most of the public sector banks have adequate training infrastructure, knowledge levels among the employees is not updated. Application of derivatives requires higher level understanding on financial markets, statistical techniques and computers. Even today, more than eighty percent of training hours is devoted for operational aspects of banking rather than knowledge inputs.
Information System
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The information systems in vogue are perfectly meeting the compliance norms but these cannot be the tools in strategic decision-making. Banks have to move from manual paper work to technology based information system. The information system should assist the decision makers in providing valuable inputs. Strong MIS backed up by comprehensive computerization is pre-requisite for successfully putting in place the Asset Liability management System in banks.
Size of t he tradi ng port folio Composi ti on of t he port foli o Holdi ng period Periodi c valuat ion Li mi ts
b.
c.
d.
e.
f. g.
h.
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Holding period
Si nce the RBI has prescri bed that the securiti es in t he tradi ng port folio has t o be sold wit hin 90 days, t he invest ment policy should prescri be t hat t he t radi ng port folio has t o be gradually bui lt over a peri od of ti me so that there is no pressure t o sell the enti re port foli o at one poi nt i n t ime. Thi s will also result in evenly spread out t rading of securi ti es. If t he port folio i s created on a part icular day it may lead t o selling the ent ire port foli o at a parti cular poi nt in ti me thereby di st orti ng t he proport ion of securit ies under available for sale, t rading and held t ill mat uri ty.
Though the system of frequent valuation of the securities in Available for Sale category is not currently proposed by RBI, the bank should periodically value the same to keep track of the status of the portfolio on a continuous basis.
It needs t o be emphasi zed t hat the syst em of followi ng average cost /wei ghted average cost /LIFO/FIFO/HIFO, etc. , do not have a sound technical basis in an economi c sense. These met hods have the pot enti al of leadi ng the bank t o wrong decisions, which may not be apparent immediately. While doi ng t rading, what is relevant for the trader is not t he pri ce at which the securi ti es were bought , but the current pri ce at whi ch t he securi ti es are being t raded. Once t he port folio is marked-t o-the-market on a frequent basis, the above practi ces wi ll lose t heir relevance.
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Position limits There is a need for the bank to clearly specify the dealer-wise position limits. The purpose of this limit is to place a ceiling on the maximum outstanding position that a dealer can have. Conclusion With the opportunities available in the secondary market of the securities, the banks have realized the importance of active trading to boost investment portfolio income and eventually the bottom line. But, exposure to the secondary market is not without its perils as the banks exposure to the interest rate and the market risk increases. Hence, active trading substantiates the requirement for incorporation of risk management tools and practices. The investment policy should take care that it has covers these aspects comprehensively to avoid any kind of undue exposure and loss to the bank.
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