CHAPTER 8

THE INVESTMENT
FUNCTION IN BANKING

FINANCIAL INSTRUMENTS
AVAILABLE TO BANKS

Each financial instrument has different

characteristics with regard to risk,
sensitivity to inflation and sensitivity to
changes in government policies and
economic conditions.
Basically they can be divided into two
broad categories depending on their
maturity:
Money market instruments
Capital market instruments

MONEY MARKET INSTRUMENTS

Definition: An instrument that has

maturity within one year and is
noted for their low risk and ready
marketability.

TYPES OF MONEY MARKET

INSTRUMENT
1.
2.
3.
4.
5.
6.
7.
8.

Treasury Bills
Bankers Acceptances
Negotiable Certificates of Deposit
Floating Rate NCDs
Commercial Paper
Government Investment Certificate
Cagamas Notes
Bank Negara Bills
4

Treasury Bills (TBs)

Treasury bills are short-term securities issued

by the Malaysian Treasury to finance its
working capital requirements.
Issued and managed by BNM on behalf of the
Malaysian Treasury.
Tenures of up to 1 year (usually for 3-month, 6month and 12-month maturities).
Issued on a discount basis by tender through
appointed principal dealers and payable at face
value on maturity date.
TBs are highly liquid and freely traded in the
secondary market.
5

Bankers Acceptances (BAs)

BA is a bill of exchange drawn on a

banking institution to finance purchase
or sale of goods for domestic and
international trade of a company.
In accepting a BA, the banker signifies
its commitment to pay the face value of
the bill to the bona fide holder upon
being presented with the BA on maturity
date.
6

A highly secure form of short-term

investment as the accepting bank is
obliged to repay the face value on
maturity.
Face values are expressed in RM in an
amount of not less than RM30,000.
Tenure of up to 1 year.
Highly liquid and freely traded in the
secondary market.

Negotiable Certificate of Deposits

(NCDs)

NCD is a receipt for a time deposit in Ringgit

placed with a commercial bank. Unlike the
receipts for ordinary fixed deposits, the NCD
is negotiable.
The name of the depositor is not stated on the
NCD and the issuer undertakes to pay the
principal sum of the deposit to whoever is the
bearer of the NCD on the date of maturity.
Issued for multiples of three months to five
years, in denomination of RM50k to RM1 mil.
8

Floating Rate Negotiable

Certificate of Deposits
(FRNCDs)

FRNCD was introduced in Jun 1988.

They have a specified tenure similar to NCDs,
but the interest rates are adjusted every 3
or 6 months based on KLIBOR.
A special feature of FRNCDs is the
adjustable rate which could minimize interest
rate risk for investors, while providing for
the issuers with longer-term funds on the
basis of shorter-term interest rates.
9

Commercial Paper

Commercial paper is an instrument issued by large

banks and corporations.
It is generally not used to finance long-term
investments but rather to purchase inventory or
to manage working capital.
It is commonly bought by money funds (the issuing
amounts are often too high for individual
investors), and is generally regarded as a very
safe investment.
As a relatively low-risk investment, commercial
paper returns are not large.
Commercial paper maturities do not exceed 270
days and proceeds typically are used only for
current transactions.
10

Government Investment
Certificate (GIC)

Introduced in July 1983.

Non-interest-bearing instruments issued by
the Government to enable Bank Islam
Malaysia Berhad and other institutions to
invest their liquid funds on an Islamic basis.
The returns are declared by the Government
on the anniversary date of issue of the
Certificates.
GICs are issued with maturities of one, two
and five years.
11

Cagamas Notes

Private debt securities issued by Cagamas Bhd,

the National Mortgage Corporation to finance
its activities to purchase housing loans from
financial institutions, corporations, and
government.
Short-term securities with tenures up to one
year.
Issued on a discount basis by tender through
appointed principal dealers and payable at face
value on maturity date.
Cagamas Notes are highly liquid and freely
traded in the secondary market.
12

Bank Negara Bills (BNBs)

BNB was introduced in Feb 1993 to encourage

savings and absorb excess liquidity from the
banking system.
BNBs are short term paper similar to the
TBs, which are issued on an auction basis.
It represents an additional money market
instrument at the disposal of the Central
Bank to influence the liquidity situation.
It provides the financial institutions with an
alternative instrument other than the TBs
and Government securities to meet the legal
requirements on their investment portfolio.
13

CAPITAL MARKET
INSTRUMENTS
Definition: An instrument that
has maturity of more than 1
year and is generally noted for
their higher expected rate of
return and capital gains
potential.
14

TYPES OF CAPITAL MARKET

INSTRUMENTS
1.
2.

Bonds (debt instrument)

Stocks (equity)

15

Bonds
1.
2.
3.

Treasury Notes and Bonds

Municipal Notes and Bonds
Corporate Notes and Bonds

16

Treasury Notes and Bonds

The safest and most liquid long-term

investment.
T-Notes and bonds are available in a
wide variety of maturities (ranging from
1 year to 10 years when issued) and in
large volume.
T- bonds and notes carry higher
expected return than bills, but greater
price risk and liquidity risk.
17

Malaysian Government
Securities (MGS)

Securities issued by the Government of

Malaysia to finance its development
projects and national debt.
Tenures up to 21 years.
Issued with a coupon interest payments
made semi-annually.
MGS are highly liquid and freely traded
in the secondary market.
18

Municipal Notes and Bonds

Long-term debt issued by states, cities, and

other government units.
Interest on the majority of these bonds is
exempted from federal income tax if they are
issued to fund public.
Capital gains on municipals are fully taxable,
except for bonds sold at discounted price.

19

Banks purchase this bond as a way of

demonstrating support for their local
communities and to attract other
business.
Municipal bonds have high credit rating
but not very liquid ( a few issues trade on
any given day and those that do trade
often report only 1 transaction per day).
2 types of municipal bond:
i) General obligation bond
ii) Revenue bond
20

i)

ii)

General obligation bond backed by

the full faith and credit of the
issuing unit of government, which
means they may be paid from any
available source of revenue.
Revenue bond can be used to fund
long-term revenue-raising projects
and are payable only from certain
stipulated sources of funds.

21

Corporate Notes and Bonds

Long-term debt securities issued by

corporations or better known as private
debt securities (PDS) in the Malaysian
capital market.
Corporate notes mature within 5 years
Corporate bonds carry longer maturities
Corporate notes and bonds generally are
more attractive to insurance companies and
pension funds than do banks because of
their credit risk and limited resale market.
However, they offer higher average yields
than government securities.
22

Cagamas Bonds

Private debt securities issued by Cagamas Bhd,

the National Mortgage Corporation to finance
its activities to purchase housing loans from
financial institutions, corporations, and
government.
Medium-term to long-term securities with
tenures normally above one year.
Issued with a coupon and redeemable at par on
maturity.
Interest is paid semiannually.
Being a negotiable instrument, Cagamas Bonds
are highly liquid and freely traded in the
secondary market.
23

Stock
1.

Preferred stock

2.

Common stock

24

Preferred Stock

Hybrid security characteristics of common

stocks and bonds.
Common stock characteristics - No fixed
maturity date, non-payment of dividends does
not bring on bankruptcy, and dividends are not
deductible for tax purposes.
Bond characteristic dividends are fixed in
amount.

25

Common Stock

Represents ownership in the corporation.

Common stock does not have a maturity date,
but exists as long as the firm does.
In the event of bankruptcy, the common
stockholders cannot exercise claims on assets
until the firms creditors, including bondholder
and preferred stockholders, have been
satisfied.

26

OTHER INSTRUMENTS
1.
2.
3.

Structured Notes
Securitized Assets
Stripped Securities

27

Structured Notes

To protect bank against shifting interest rates.

The interest yield of this security could be
periodically reset (quarterly, semiannually, or
after a certain number of years) based on what
happened to a stated reference rate, such as
the T-bills or bond rate.
A guaranteed floor rate and cap rate could be
added in which the banks return could not drop
below a stated (floor) level or rise above
maximum (cap) level.
28

Securitized Assets

A hybrid security based upon pools of

loans.
This security is backed by selected
loans of uniform type and quality, such
as home mortgages, automobile loans,
and credit card loans.
The most popular securitized assets
that banks and thrift institutions buy
as investment today are based upon
mortgage loans.
29

Advantages:
i) Guarantees from government agencies
(in the case of home-mortgage-related
securities) or from private institutions
(banks or insurance companies).
ii) The higher average yields available on
securitized assets than government
securities.
iii) The superior liquidity and
marketability of securities backed by
loans compared to loans themselves.
30

Stripped Securities

A claim against either the principal or

interest payments associated with a
debt security, such as Treasury bond.
Some stripped securities offer
interest-rate hedging possibilities to
help protect a portfolio of bonds and
other traditional security holdings
against loss from interest-rate
changes.
31

The two securities whose interest

and principal payments are most likely
to be stripped today are longer-term
(10 years and longer) securities such
as Treasury bond and mortgagebacked securities.

32

FACTORS AFFECTING CHOICE OF

INVESTMENT SECURITIES
1.
2.
3.
4.
5.
6.
7.

Expected rate of return

Tax exposure
Interest rate risk
Credit risk
Business risk
Liquidity risk
Call risk
33

FACTORS AFFECTING CHOICE

OF INVESTMENT SECURITIES
8.
9.
10.

Prepayment risk
Inflation risk
Pledging requirements

34

1) Expected Rate of Return

The investments officer must

determine the total rate of return that
can reasonably be expected from each
security, including the interest
payments promised by the issuer of
that security and possible capital gains
or losses.

35

For most investments, this requires

the investment manager to calculate
the yield to maturity (YTM) if a
security is to be held to maturity or
the planned holding period yield
(HPY) between point of purchase and
point of sale.

36

i) Yield to Maturity

The YTM determines the rate of discount

(or yield) on a loan or security that equalizes
the market price of the loan or security with
the expected stream of cash flows (interest
and principal) that loan or security will
generate.
Example: Suppose the officer is considering
purchasing a RM1,000 Treasury note that
promises an 8% coupon rate and mature in 5
years. If the T-notes current price is
RM900, find the YTM.
37

Yield to Maturity:
n

CPt
FVn
PVBond

t
n
(1

YTM)
(1

YTM)
t 1
where CP are the annual coupon payments on the security and
where FV is the face value of the security

38

RM900 = 80 (1+YTM)-1 + 80 (1+YTM)-2+.+

80 (1+YTM)-5 + 1000 (1+YTM)-5
Solve by using interpolation or financial
calculator and we will get the YTM is 10.74%.
The calculated YTM should be compared with
the expected yields on other loans and
investments that might be acquired in order
to determined where the best possible rate
of return.

39

ii) Holding Period Yield

Some banks frequently do not hold all their

security investments to maturity.
Some securities must be sold off early to
accommodate new loan demand or to cover
deposit withdrawals.
So, the investments officer needs to know
how to calculate the holding period yield
(HPY).

40

The HPY is the rate of return that

equates a securitys purchase price
with the stream of income expected
from that security until it is sold to
another investor.
Example: Suppose the 8% Treasury
note described earlier and currently
priced at RM900 was sold at the end
of 2 years for RM950.

41

Holding Period Yield:

CPt
P
PV

HP
(1

HPR)
(1

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

42

RM900 = 80 (1+HPY)-1 + 80 (1+HPY)-2 +

950 (1+HPY)-2
Solve by using interpolation or
financial calculator, the HPY would be
11.51%.

43

2) Tax Exposure

Interest and capital gains income

from investment held by banks are
taxed as ordinary income for tax
purposes.
Because of their relatively high tax
exposure, banks are more interested
in the after-tax rate of return on
loans and securities than in their
before-tax return.
44

3) Interest Rate Risk

Changing interest rate will create risk for

investments.
Rising interest rates will lower the market
value of bonds and notes, with the longestterm security suffering the greatest
losses.
Hence, a growing number of tools to hedge
interest rate risk have appeared in recent
years financial futures, options, interestrate swaps, gap management, and duration.
45

4) Credit or Default Risk

The security investments made by banks are

closely regulated due to the credit risk
displayed by many securities, especially
those issued by private corporations and
some local governments.
The risk that the security issuer may default
on the principal or interest owed on a bond
or note.
Banks are prohibited to invest in securities
that are rated below Baa by Moodys or BBB
on Standard & Poors bond-rating schedule.
46

Banks are generally allowed to buy only

investment-grade securities, rated at least Baa
or BBB, in order to protect the depositors
against excessive risk.
In recent years, bankers and other financialservice managers have helped develop new
methods for dealing with credit risk in both
their investments and their loans.
Example, bank officers may be able to find
another financial institution, often an insurance
company, willing to swap an uncertain return on
securities the banks hold.

47

5) Business Risk

Banks and other financial institutions of all

size face significant risk that economy of
the market area they serve may turn down,
with falling business sales and rising
bankruptcies and unemployment. This
adverse development is often called
business risk.
Because business risk is always present,
many banks rely heavily on their security
portfolios to offset the impact of
economic risk on their loan portfolios.
48

6) Liquidity Risk

Banks must be ever mindful of the

possibility they will be required to sell
investment securities in advance of their
maturity due to liquidity needs and be
subjected to liquidity risk.
Thus, a portfolio manager must select the
liquid securities that have a ready market,
relatively stable price over time, and high
probability of recovering the original
amount invested.
49

Treasury securities are generally the

most liquid and have the most active
resale markets, followed by federal
agency securities, municipal bonds, and
mortgage-backed securities.

50

7) Call Risk

Many corporations and some

governments that issue investment
securities reserve the right to call in
those instruments in advance of their
maturity and pay them off.
Such calls usually take place when
market interest rates have declined
and the borrower can issue new
securities bearing lower interest
costs.
51

So, the bank investing in callable

securities will face the risk of an
earnings loss because it must reinvest
its recovered funds at lower interest
rates.
Investment officers generally try to
minimize this call risk by purchasing
callable securities bearing longer call
deferments or simply by avoiding the
purchase of callable securities.

52

8) Prepayment Risk

A form of risk specific to certain

kinds of investment securities,
especially asset-backed securities.
This form of risk arises because the
realized interest and principal
payments (cash flow) from a pool of
securitized loans may be quite
different from the payments (cash
flows) expected originally.
53

9) Inflation Risk

Banks must be alert to the possibility

that the purchasing power of both
the interest income and repaid
principal from a security or loan will
be eroded by rising prices for goods
and services called inflation.
Inflation can erode the value of the
stockholders investment in a bank
its net worth.
54

Some protection against inflation risk

is provided by short-term securities
and those with variable interest
rates, which usually grant the
investments officer greater
flexibility in responding to any flareup in inflationary pressures.

55

10) Pledging Requirements

The collateral needed when investing

in any securities in order to
safeguard public funds.
Example: When a bank borrows from
the discount window of the central
bank, it must pledge either
government securities or other
collateral acceptable to the central
bank.
56