Managing the Banks Investment Portfolio

Outline
      Why there is the need of managing investment portfolio in banking? Which investment alternatives are available for a bank? Which factors affect the choice of a banker among investment alternatives? What are major techniques of managing an investment portfolio of a bank? How liquidity is managed in investment portfolio? Practical example of a local bank's security portfolio?

Introduction
Portfolio theory is an investment approach developed by University of Chicago economist Harry M. Markowitz (1927 - ), who won a Nobel Prize in economics in 1990. Portfolio theory allows investors to estimate both the expected risks and returns, as measured statistically, for their investment portfolios. Markowitz described how to combine assets into efficiently diversified portfolios. It was his position that a portfolio's risk could be reduced and the expected rate of return could be improved if investments having dissimilar price movements were combined. In other words, Markowitz explained how to best assemble a diversified portfolio and proved that such a portfolio would likely do well.

Definition of Portfolio:
Portfolio is a collection of investments held by an institution or an individual. Holding a portfolio is a part of an investment and risk-limiting strategy called diversification. What does it mean to diversify your investments? It simply means that you put your money in a wide range of different investments. Whatever it may be that you are investing in, be sure to spread your money around. It is important to do this in order to spread out your risk. If you have all

your money in a single investment and that investment goes broke, you are in big trouble. If you have your money spread you in multiple investments and one goes bad, you still have all the others to "protect" you. For example, if you are investing in stocks, being properly diversified means that you will have multiple stocks. You should be buying stocks in different companies, as well as different types of companies. Don't buy just technology stocks, or oil, or pharmaceuticals. Why not? Because if something goes bad with a single industry, you won't loose as much. This is the basis of what diversification is - mitigating risk. The same idea holds true for other types of investments. If you are buying mutual funds, you are already somewhat diversified, as each fund holds dozens of different stocks. However, you can extend this diversification further by investing in multiple types of mutual funds. Some may buy tech stocks, others may buy bonds or stocks of large companies. With a few good mutual fund picks, you can achieve a wide range of diversification much more easily than when you pick the stocks individually. The higher the risk of your investment, the more important proper diversification becomes. Of course, proper diversification would mean that you should have multiple types of investments. It's a good idea to own a little of many things, including stocks, bonds, mutual funds. Depending on your tolerance for risk, you can choose safer or riskier investments in each category. But even if you are taking a riskier route, it's still a good idea to spread the risk - some stocks, a few mutual funds! By owning several assets, certain types of risk (in particular specific risk) can be reduced. The assets in the portfolio could include bank accounts, stocks, bonds, options, warrants, gold certificates, real estate, futures contracts, production facilities, or any other item that is expected to retain its value. In building up an investment portfolio a financial institution will typically conduct its own investment analysis, while a private individual may make use of the services of a financial advisor or a financial institution which offers portfolio management services. Portfolio management involves deciding what assets to include in the portfolio, given the goals and risk tolerance of the portfolio owner. Selection involves deciding which assets to acquire/divest, how many to acquire/divest, and

when to acquire/divest them. These decisions always involve some sort of performance measurement, most typically the expected return on the portfolio, and the risk associated with this return (e.g., the expected standard deviation of the expected return). However, due to the almost-complete uncertainty of future values, this performance measurement is often done on a casual qualitative basis, rather than a precise quantitative basis (which would give a false sense of precision). Typically the expected returns from portfolios of different asset bundles are compared. The unique goals and circumstances of the investor must also be considered. Some investors are more risk averse than others.

Portfolio management process:

Managing investment portfolios is an ongoing process. It consists of several steps:
       

Identifying and specifying investment objectives and constraints Developing investment strategies Deciding portfolio composition in detail Portfolio managers initiating portfolio decisions Traders implementing portfolio decisions Measuring and evaluating portfolio performance Monitoring investor and market conditions Implementing any necessary rebalancing

The portfolio management process broadly consists of three steps: Planning, Execution and Feedback.


The planning step begins with identifying the investor s objectives and constraints. A Once these are established, an investment policy statement can be written to act as a guideline for future investment decisions. Longterm expectations for the capital markets will then be used to create a strategic asset allocation suitable to the objectives and constraints outlined. The execution step puts the plan into action. Specific assets can be selected, and decisions can be made on how best to implement the

strategic plan. The portfolio can be optimized using quantitative tools and at times it may be deemed appropriate to make tactical alterations to the long-term strategic asset allocation. The feedback step consists of ongoing monitoring of the portfolio and rebalancing to the strategic asset allocation when needed. It also entails an evaluation of the performance not only how well the portfolio performed but what factors contributed to the performance.

Investment Alternatives Available to Banks

The number of financial instruments available for banks to add to their securities portfolio is both large and growing. Moreover each financial instrument has different characteristics with regard to risk, sensitivity to inflation and sensitivity to shifting government policies and examines condition. To examine the different investment vehicles open to banks it is useful to divide them into two large groups: (1) money market instruments, which reach maturity within one year and are noted for their low risk and ready marketability, (2) capital market instruments, which have remaining maturities beyond one year and are generally noted for their higher expected rate of return and capital gains potential.

Money Market Instruments

One of the most popularl of all short term investments is the us treausry bill, a debt obligation of the united states government, that by law must mature within one year from date of issue, three maturities of bills are routinely issued in weekly and monthly auctions: three-and six month bill in each week and oneyear bills once each month. Bills are particularly attractive to banks because of their high degree of safety. Bills are supported by the taxing power of the federal government, their market prices are relatively stable, and they are readily marketable. Moreover T-bills are serving as collateral for attracting loans from other institutions through repurchase agreement and other borrowing instruments. Bills are issued and traded at a discount from their par (face) value without a promised interest rate. Thus, the investors return consists purely of price appreciation as the bill approaches maturity. The rate of return (yield) on T-

bills is figured by the bank discount method. This uses the bills par value at maturity as the basis for calculating its return. Ignores the compounding of interest, and is based on a 360-day year.

Short-Term Treasury Notes and Bonds

At the time they are issued, Treasury notes and Treasury bonds have relatively long maturities: 1 to 10 years for notes and over 10 years for bonds. However, when these securities come within one year of maturity, they are considered money market instruments. While Treasury notes and bonds are more sensitive to interest rate risk and less marketable then Treasury bills, their expected returns (yields) are usually higher than for bills with greater potential for capital gains. Treasury notes and bond are coupon instruments, which means they promise investors a fixed rate of return, though the expected return may fall below or climb above the promised coupon rate due to fluctuations in the security s market price. Beginning in July 1986. All negotiable Treasury Department securities were converted to electronic book entry, with no registered or engraved certificates issued. This system, known as Treasury Direct, supplies bank and non bank owners of U.S. Treasury securities are statement showing the bills, notes, and bonds they hold. Any interest and principal payments earned or deposited directly into the owners checking or savings account. This approach means not only greater convenience for banks and other investors purchasing and selling Treasury securities but also provides increased protection against theft.

Federal Agency Securities

Marketable notes and bonds sold by agencies owned by or started by the federal government are known by federal agency securities. Familiar examples include securities issued by the Federal National Mortgage Association (FNMA, or Fannie Mae), the farm credit system (FCS), the Federal Land Banks(FLBs), the Federal Home Loan Mortgage Corporation (FHLMC, or Freddie Mac), and the Student Loan Marketing Association (SLMA, or Sallie Mae). Most of the securities are not formally guaranteed by the federal government, though most financial

analyst believes Congress would move quickly to rescue and agency in trouble. This employed government support keeps agency yields close to those on Treasury securities (normally within one percentage point) and contributes to the high liquidity of most agency securities. Among the most popular of all federal agency securities are discount notes. These short- term agency borrowings are sold at prices below their face value and usually have a maturity range of overnight to one year. Most discount notes are issued in book entry form. Though a few are still available as bearer certificates, with yields figured (as with Treasury bills) on a 360- day basis. Interest income on agency- in most cases. Subject to state and local taxation as well.

Certificates of Deposit
A certificate of deposit (CD) is simply an interest- bearing receipt for the deposit of funds in a bank or non bank thrift institution. Thus, the primarily role of CDs is to provide banks with an additional source of funds. However, banks often buy the CDs issued by other depository institutions, regarding them as an attractive, lower- risk investment. CDs carry a fixed term, and there is a federally imposed penalty for early withdrawal. Banks and thrift issue both small consumer- oriented CDs regarding in denomination from $500 to $100000, and large business oriented or institution- oriented CDs (often called jumbos), with denominations over $100000 (though only the first $100000 is federal issued). And negotiated interest rates that, while normally fixed, may be allowed to fluctuate with market condition. Securities dealers make an active secondary market for $100000- plus CDs maturing within six months.

International Eurocurrency Deposits

The 1950s in Western Europe ushered in the development of high- quality international bank deposits, sold in million- dollar units and denominated in a currency other than the home currency of the country in which they are deposited. Eurocurrency deposits are not checking accounts, but time deposits of fixed maturity issued by the world s largest banks head quartered in financial centers around the globe, though the heart of the Eurocurrency deposits market

is in London. Most of these international deposits are of short maturity-30, 60, or 90 days-to correspond with the funding requirements of international trade. They are not insured, and due to their perceived higher credit risk, lower liquidity, and greater sensitivity to foreign economic and political developments, they normal carry slightly higher market yields than domestic time deposits issued by comparable- size U.S. banks. Bankers Acceptance Because they represent a bank s promise to pay the holders a designated amount of money (indicated on the face of the acceptance) on a designated future date, bankers acceptances are considered to be among the safest of all money market instruments. Most acceptances arise from a bank s decision to guarantee the credit of one of its customers who is exporting, improving or storing goods or purchasing currency. In legal language, the bank agrees to be the primarily obligor, committed to paying off the customer s debt regardless of what happens subsequently, in turn for a fee. Through the acceptance vehicle, the bank supplies its name and credit standing so the customer will be able to obtain credit from someone else more easily and at lower cost. The holder of the acceptance on its maturity date may be another bank or a money market investor attracted by its safety and active resale market. Because acceptances have a ready resale market, they may be traded from one investor to another before reaching maturity. If a bank sells the acceptances it holds, this does not erase the issuing banks obligation to pay off its outstanding acceptances at maturity. However, by selling an acceptance, a bank adds to its reserves and transfers interest rate risk to another investors. The acceptance is a discount instrument and, therefore is always sold at a price below par before it reaches maturity. As it with Treasury bills, the investor s expected return comes solely from the prospect that the expectance will rise in price as it gets closer to maturity. Rates of return on acceptances generally lie between the yield on euro currency deposits and the yield on treasury bills. One other important advantage of acceptances is that they may qualify for discounting (borrowing) at the Federal Reserve Banks, provided they qualify as eligible acceptances. You be eligible as

collateral for borrowing from the Fed, the acceptance must be dominated in dollars, normally can t exceeds six months to maturity, and must arise from the export or import of goods or from the storage of marketable staples.

Commercial paper
Many smaller banks find commercial paper- short term; unsecured IOUs offered by major corporations- an attractive investment that is safer than most types of bank loans. Commercial paper sold in the United States is of relatively short maturity- the bulk of it matures in 90 days or less- and generally is issues by borrowers with the highest credit ratings. A rapidly developing market in western euro and in Japan for euro paper has attracted participation by major international bans. Euro paper generally caries longer maturities and higher interest rates than U.S. commercial paper due to its greater perceived credit risk; however, there is a more active resale market for Euro paper then for most U.S. commercial paper issues. Most commercial paper is issued at a discount for par, like T-bills and acceptances. Though some paper bearing a promise rate of return (coupon) is also issued today.

Short term municipal obligation

State and local governments, including countries, cities, and special districts, issue a wide variety of short- term debt instruments to cover temporary cash storages. Two of the most common are tax- anticipation notes (TANs), issued in lieu of expected future tax revenues, and revenue- anticipation notes (RANs), and issued to cover expenses from special projects, such as the construction of a toll bridge, highway, or airport, in lieu of expected future revenues from those projects. All interest earned on such municipal notes is exempt from federal income taxation, so they are attractive to banks.

Capital Market Instruments

Treasury Notes and Bonds Over One Year to Maturity Among the safest and most liquid long term investments that banks can make are U.S. Treasury notes and bonds. U.S. Treasury notes are available in a wide variety of maturities (ranging from 1 year to 10 years when issued) and traded in a more limited market with a wider price fluctuations than is usually the case with Treasury notes. Treasury bonds and notes carry higher expected returns than bills, but present a bank with greater price risk and liquidity risk. They are issued normally in dominations of $1000, $5000, $10000, $100000 and $1 million. A developing limitation of U.S. Treasury notes and especially of the longest term Treasury bonds is a declining supply of these instruments available to banks and other investors. With a stronger economy and rapidly growing tax collections, federal government revenues expanded significantly during the 1990s and into the new century, leading to substainal budget surpluses and reduced government needs to borrow. Many of these surplus funds have been devoted to retiring longer-term Treasury securities putting strong upwards pressure on the prices of remaining Treasury securities and forcing many banks investment managers to look for new types of investments that are in much more abundant supply. Such as selected federal agency securities.

Municipal Notes and Bonds

Long term debt obligation is issued by states, cities and governmental units are known collectively as municipal bonds. As with short term municipal notes interest on the maturity of these bonds is exempt from federal income tax provided they are issued to fund public, rather than private, projects. Capital gains on municipal are fully taxable, however, except for bonds sold at a discounted price, where the gain from purchase price to par value is considered a portion of the investor s tax exempt interest earnings banks often submit competitive bids for a purchase after private negotiation of the debt issued by local cities, countries and schools district as a way of demonstrating support for their local communities and to attract other business. They also purchased

municipal securities from brokers and dealers in the national market for reasons strictly related to after tax return and risk, because many municipal bonds have high credit ratings and an active resale market. Many different types of municipal bonds are issued today but the majority falls into one of two categories (1) general obligation (Go) bonds backed by the full faith and credit of the issuing unit of government, which mean they may be paid from any available source of revenue (including the levying of additional taxes): and (2) revenue bonds which can be used to fund long-term revenue raising projects and are payable only from certain stipulated sources of funds. U.S. banks have long possessed the authority to deal in and underwrite general obligation (GO) municipal bonds, but for many years faced restrictions on direct underwriting of municipal revenue bonds until this power was extended with passage of the Gramm-Leach-Billey Act in 1999.

Corporate Notes and Bonds

Long-term debt securities issued by corporations are usually called corporate notes when they mature within five years or corporate bonds when they carry longer maturities. There are many different varieties, depending on the types of security pledged (e.g. mortgages versus debentures), purpose of issue, and terms of issue. Corporate notes and bonds generally are more attractive to insurance companies and pension funds than to banks because of their higher credit risk relative to government securities and their more limited resale market. However, they do offer significantly higher average yields than government securities of comparable maturity.

Other Investment Instrument Developed More Recently

The range of investment opportunities for banks has expanded tremendously in recent years. Many new securities have been developed: some of these are variations on traditional notes and bonds, while other represent entirely new investment vehicles. Examples include structured notes, securitized assets, and shipped securities.

Structured Notes
In their search to protect themselves against shifting interest rates many banks have added structured notes to their investments portfolios. Most of these loans arise from securities brokers and dealers who assemble pools of federal agency securities (issued by such well known agencies as the federal home loan banks) and offer a bank s investment officer at package investment whose interest yield may be periodically reset (perhaps every quarter, semi annually, or after a certain number of years) based on what happens to the started reference rate, such as the U.S. Treasury bill or bond rate. A guaranteed floor rate and cap rate may be added in which the bank s promised investment return may not drop below a stated (floor) level or rise above some maximum (cap) level. Some structure notes carry multiple coupon rates that periodically given a boost (set up) to give investors a high yield; others have adjustable coupon (promised) rates determined by a specific formula. The complexity of these notes has resulted in substainal losses for some banks, not from credit risk, because few of these notes are actually defaulted upon, but from substainal interest rate risk.

Securitized Assets
In recent years hybrid securities based upon pools of loans have been one of the most rapidly growing bank investments. These securitized assets are backed by selected loans of uniform type and quality, such as FHA- and VAinsured home mortgages, automobile loans, and credit card loans. The most popular securitized assets that banks buy as investment today are based upon mortgage loans.

Stripped Securities
In the early 1980s, security dealers developed and marketed a hybrid instrument known as stripped security, a claim against either the principal or interest payment associated with the debt security, such as U.S. Treasury bond. Dealers create stripped securities by separating the principal and interest payments from an underlying debt security and selling separate claims to these two promised income stream.

Investment The Crossroad Account on a Bank s Balance Sheet

Why need of portfolio investment

We all know that investment is not a sure thing in most of case, there are much like a game that you don t know the result until the game has been played and a winner has been declared, so you need strategy in investing. Basically, an investment strategy is a plan for invest your money in various types of investments that will help you to get your financial goals in specific amount and time. Every type investment contains individual investment that you must choose one that suitable for you. For example: You could find to invest in clothing store or invest in stock market. First, you should make research, it could make very confusing because there are so many different types of investments and individual investments to choose from. This is the importance of your strategy to combine the risk tolerance and investment style all style into play. If you re new to investment and still confuse to make decision ,you need closely with a financial planner before making any investments that can help you to guide and develop an investment strategy to achieve your financial goals that will not fall within the bounds of your risk tolerance and your investment style. You must having a goal and strategy in investment. Never invest money without having a goal and a strategy for reaching your goal! This is essential. Nobody hands their money over to anyone without knowing what their money is being used for and when they will get it back! If you don t have a goal, a plan, or a strategy, that is essentially what you are doing! Always start with a goal and a strategy for reaching that goal! To make your investment success, it needs Portfolio Diversification. The key is to invest in several different areas is not just one, but many kinds of types. For example: It may include purchasing bonds, investing in money market accounts, or even in some real property. A good diversification usually includes stocks, bonds, real property, and cash. It may take time to diversify your portfolio. If you divide your investment into various types, you still have a lower risk in losing your money and you will see better returns. For example: if you have invested in ten different stocks, and nine are doing well while one plunges, you are still in reasonably good shape.

Factors affect the choice of a banker among investment alternatives:

Investment can be said to be an art. Many people invest money without knowing what they are doing. Only a few people really understand the art of investing money. They invest according to certain principles. There are also certain factors that affect the investment decisions. All these are done mainly to increase the return on the investment and also to keep the risk to a minimum. The various factors that affect the investment decisions are given below:          Expected rate of return Tax exposure Interest rate risk Credit risk Business risk Liquidity risk Call risk Prepayment risk Inflation risk

Expected rate of return

The main reason for people investing money is to earn a high return on the investment. An individual may have various investments. Some may be fixed investments and others may be high risk equity investments. The individual has to periodically analyze the rate of return that is being earned from various investments. The portfolio of the investments may have to be readjusted depending on the rate from each of the investments. This will help the investor to earn an increased rate of return from various investments.

Tax exposure
Tax benefits are a very important aspect to be considered when a person is investing. Tax can wipe away the return on investment if the investment is not done wisely. There are various investment options that are taxed highly. There are other investments for which the returns are either not taxed or have a low tax. The individual has to understand the tax laws of the land and invest accordingly to make high return on investment.

Interest rate risk

The danger that shifting market interest rate can reduce bank net income or lower the value of bank assets and equity. Changing interest rates create real risk for the bank s investment officer. Rising interest rates lower the market value of previously issued bonds and notes, with long-term security issue generally suffering the greatest losses. Moreover, periods of rising interest rates are often marked by surging loan demand, because a banker s first priority is to make loans, many security investments must be sold of to generate cash for lending. Such sales frequently result in substantial capital losses which the banker hopes to contract by combination of tax benefits and the relatively higher yields available on loans. A growing number of tools to hedge (contract) interest rate risk have appeared in recent years, including financial futures contracts, option contracts, interest rate swaps, gap management, and duration.

Credit or default risk:

The danger that a bank s extensions of credit will not pay out as promised, reducing the bank s profitability and threatening its survival .

In other words, Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Another term for credit risk is default risk. Investor losses include lost principal and interest, decreased cash flow, and increased collection costs, which arise when a consumer or business does not make a payment due on mortgage loan, credit card, line of credit or other loan etc. Bankers have helped to developed new method for dealing with credit risk in both their investment and their loans in recent year.

Business risk
The danger that changes in the economy will adversely affect the bank s income and the quality of its assets. Banks of all sizes face significantly risk that the economy of the market areas they serves may turn down, with falling business sales and rising bankruptcies and unemployment. These adverse developments, often called business risk , would be reflected quickly in the bank s loan portfolio where delinquent loans would rise as borrowers struggled to generate enough cash flow to pay the bank. Because business risk is always present, many banks rely heavily on there security portfolios to offset the impact of economic risk on their loan portfolios. This usually means that many of securities purchased by the bank will come from the borrowers located out side the bank s market for loans. Bank examiners encourage out-of-market security purchases to balance risk exposure in the loan portfolio.

Liquidity risk
The danger that a bank will experience a cash shortage or have to borrow at high cost to meet its obligations to pay. Banks must be ever mindful of the possibility they will be required to sell investments securities in advance of their maturity due to liquidity risk. Thus, a key issue that a portfolio manager must face in selecting a security for investment purposes is the breadth and depth of its sale market. Liquid securities are, by definition , those investments that have a ready market, relatively stable price over time, and high probability of recovery the bank s original invested capital(i.e., the risk to principal is low). Unfortunately, the purchases of a large volume of liquid, readily marketable securities tends to lower a bank s average yield from its earning assets and, other factors held constant, tends to reduce its profitability . Thus, bank management faces a trade-off between profitability and liquidity that must be reevaluated daily as market interest rates and the bank s exposure to liquidity risk change.

Call risk
The danger that investment securities held by a bank will be retired early, reducing the bank s expected return. 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. Because such calls usually take place when market interest rates have declined(and the borrower can issue new securities bearing lower interest costs ), the bank investing in callable bonds and notes runs the risk of an earnings loss because it must reinvest its recovered funds at today s lower interest rates. Banks generally try to minimize this call risk by purchasing bonds bearing longer call deferments (so that a call cannot occur for several years) or simply by avoiding the purchase of callable securities. Fortunately for bank investment officer and other active investors, call privileges attached to bonds have being declining

significantly in recent years due to the availability of other tools to manage interest rate risk.

Prepayment risk
The danger that banks holding loan-backed securities will receive a lower return because some of loans backing the securities are paid off early.

Explanation
It s mean that the bank may earn less return than expected form the securities which bank receive from the customer by issuing the loan. This type of risk arises because the interest and the principal payment of the loans which issues against the securities may be quite different from the expected one. These variations may arise from; First is the Loan refinancing, which increase when the market interest rate fall. Borrowers may believe that they will save on the loan payments if they repay their existing loan and take the new one with lower interest rate. Second is the turnover of assets behind the loan, which may disappear when the customer default on their loans or in any other condition. In both the cases, some of the loans will be terminated or paid off and generated the smaller cash flow than expected which lead to the lower the expected rate of return to a bank. When the interest rate drop below than the interest rate attach with the loan, more & more borrowers will repay their loans early. And the repayment risk of the increase. To reduce the prepayment risk, bank must make some reasonable assumption regarding the volume of loans that might be prepaid. In order to estimate the prepayment of loans, bank investment officer must consider the following factor;  Expected market interest rate  Condition of economy  How older the loans in the pool are. (Because there is less chance of prepayment of new loan than old one s.)

Always, fall in the interest rate may not adverse for the bank and other holders of the loan backed securities. Because prepayment may accelerate, a bank to recover its cash at faster rate, which can be favorable development if the bank use that cash in some other profitable investment such as, making direct loans to customer.

Inflation risk
The danger that rising prices of goods and services will result in lower bank returns or reduced values in bank assets and equity. Each of the persons investments have to beat the inflation rate present at that time for the return on investment to be positive. If the inflation rate is more than the return on the investment of a person, then the return is negative when inflation is taken into consideration. Any investment has to beat the inflation to be efficient. While there is less of a problem today then in the 1970s, 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. Inflation can also erode the value of the stockholder s investment in a bank-its net worth. Some protection against inflation risk is provided by shortterm securities and those with variable interest rates, which usually grant the bank s investment officer greater flexibility in responding to any flare-up in inflationary pressures.

Major techniques of managing an investment portfolio of a bank:

For almost every field of studies, from engineering to businesses, there exists the need for acquiring some basic concepts to apply them in suitable situations for that field. In the field of investing and asset allocation, there is no exception also.

There are certain techniques if you were to diversify into uncountable number of stocks or many different assets within an asset class, or managing a portfolio of different types of asset classes.  Variance and standard deviation  Covariance  Correlation  Alpha  Beta  Sharpe Ratio.

Variance and standard deviation

As most will have heard before, variance and standard deviation are statistical definitions of risk. Bear in mind that there are many meanings of risk as will be explained and elaborated later. What the numbers of standard deviation means in lay man terms is simply the degree of dispersion of the asset s prices around its arithmetic mean over a chosen time period. You can see it this way, in general, a relatively high standard deviation of returns means that there is a high chance that actual return when cashing out from that asset will be different from its mean over holding period and vice versa. Variance is the square of standard deviation, because the changes in price of assets will sometimes be higher or lower than its arithmetic mean, hence the need to square the differences between the return at each point of time and mean over the time period chosen, before adding together and the average of the sum is then called variance, square root variance is then called standard deviation.

A caveat is that standard deviation differs a lot depending on your chosen time period. This is not surprise, considering that the mean of the asset returns depends on the period of time used to calculate it. For the case of stocks, it is a common knowledge that standard deviation is much higher when measure over weeks and months than is when measure over years and decades.

Covariance
The value of covariance quantifies the degree to which two distinct assets move together. This value between two pairs of assets has deep significance when it comes to deceasing volatility of a portfolio of assets without decreasing expected returns the ultimate objective of asset allocation anyway. You can

interpret covariance this way, the higher the covariance between two pairs of assets within the same asset class or two different asset classes, the higher the correlation between those assets or asset classes and the higher the volatility, and of course vice versa.

Correlation
The correlation coefficient measures and quantifies the degree of positive or negative association between two sets of data. A positive correlation does not mean causation; it may mean that both are caused by the same causes. But finding correlation is essential if one wants to find causation. One of the main objectives behind asset allocation is to discover pairs of assets or asset classes that have quite stable and negative correlations with each other, or at least low correlations. The rationale behind is simple, so that the overall values of your

portfolio will remain stable even though there is great volatility in today financial markets. Correlation is simple to understand conceptually, in the simplest sense; a positive correlation means that between two data series, one move in the same direction as the other one at the same time. In other words, when the first asset increase in price, the second one also increase in price and vice versa. A zero correlation means that the two sets of data are totally unrelated to each other. The degree or extent of correlation is indicated by a value ranging from -1 to +1.

Alpha
Alpha gives you an idea of the degree in which that asset can generate returns lower, equal to, or higher than the expected returns, given the volatility of this asset relative to its market benchmark index. Put it in another words, it measures excess return if an asset relative to its beta.

Beta
In layman terms, beta gives an indication of how much percent change of the asset price for a given percentage in price of the market for that asset class as a whole. If you came across modern portfolio theory, beta is actually the asset s market risk. Every financial asset, especially stocks, consists of market risk and company specific risk. Put it another way, beta can be interpreted as the extent of an asset s market, systematic risk that cannot be diversified away. Beta of greater than one means that asset price will change in price greater than the percentage change in the overall market price of all assets in that particular asset class. Less

than one is of course asset price changes less than broad market price changes and beta of one is when asset has same percentage change in price with the same price change in market.

Sharpe Ratio
Named after a Nobel Laureate, William F. Sharpe, this ratio is nothing fantastic or rocket science. It is a ratio of the mean return of an asset over its standard deviation. As a result, Sharpe ratio is also known as reward-to-variability ratio. Sharpe ratio is similar to alpha in the sense that both measures excess return of an asset over a risk free return benchmark, just that one is comparing to its beta and another is to its own standard deviation.

How liquidity is managed in investment portfolio

Market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value. Money, or cash in hand, is the most liquid asset, and can be used immediately to perform economic actions like buying, selling, or paying debt, meeting immediate wants and needs. An act of exchange of a less liquid asset with a more liquid asset is called liquidation. Liquidity also refers both to a business's ability to meet its payment obligations, in terms of possessing sufficient liquid assets, and to such assets themselves. A liquid asset has some or more of the following features. It can be sold rapidly, with minimal loss of value, any time within market hours. The essential characteristic of a liquid market is that there are ready and willing buyers and sellers at all times. Another elegant definition of liquidity is the probability that the next trade is executed at a price equal to the last one. A market may be considered deeply liquid if there are ready and willing buyers and sellers in large

quantities. This is related to the concept of market depth that can be measured as the units that can be sold or bought for a given price impact. The opposite concept is that of market breadth measured as the price impact per unit of liquidity. An illiquid asset is an asset which is not readily saleable due to uncertainty about its value or the lack of a market in which it is regularly traded. The mortgage-related assets which resulted in the subprime mortgage crisis are examples of illiquid assets, as their value is not readily determinable despite being secured by real property. Another example is an asset such as a large block of stock, the sale of which affects the market value. The liquidity of a product can be measured as how often it is bought and sold; this is known as volume. Often investments in liquid markets such as the stock market or futures markets are considered to be more liquid than investments such as real estate, based on their ability to be converted quickly. Some assets with liquid secondary markets may be more advantageous to own, so buyers are willing to pay a higher price for the asset than for comparable assets without a liquid secondary market. The liquidity discount is the reduced promised yield or expected return for such assets, like the difference between newly issued U.S. Treasury bonds compared to off-the-run treasuries with the same term remaining until maturity. Buyers know that other investors are not willing to buy off-the-run so the newly issued bonds have a lower yield and higher price. Speculators and market makers are key contributors to the liquidity of a market, or asset. Speculators and market makers are individuals or institutions that seek to profit from anticipated increases or decreases in a particular market price. By doing this, they provide the capital needed to facilitate the liquidity. The risk of illiquidity need not apply only to individual investments: whole portfolios are subject to market risk. Financial institutions and asset managers that oversee portfolios are subject to what is called "structural" and "contingent" liquidity risk. Structural liquidity risk, sometimes called funding liquidity risk, is the risk associated with funding asset portfolios in the normal course of business. Contingent liquidity risk is the risk associated with finding additional funds or replacing maturing liabilities under potential, future stressed market conditions. When a central bank tries to influence the liquidity (supply) of money, this process is known as open market operations.

In banking, liquidity is the ability to meet obligations when they come due without incurring unacceptable losses. Managing liquidity is a daily process requiring bankers to monitor and project cash flows to ensure adequate liquidity is maintained. Maintaining a balance between short-term assets and short-term liabilities is critical. For an individual bank, clients' deposits are its primary liabilities (in the sense that the bank is meant to give back all client deposits on demand), whereas reserves and loans are its primary assets (in the sense that these loans are owed to the bank, not by the bank). The investment portfolio represents a smaller portion of assets, and serves as the primary source of liquidity. Investment securities can be liquidated to satisfy deposit withdrawals and increased loan demand. Banks have several additional options for generating liquidity, such as selling loans, borrowing from other banks, borrowing from a central bank, and raising additional capital. In a worst case scenario, depositors may demand their funds when the bank is unable to generate adequate cash without incurring substantial financial losses. In severe cases, this may result in a bank run. Most banks are subject to legally-mandated requirements intended to help banks avoid a liquidity crisis. Banks can generally maintain as much liquidity as desired because bank deposits are insured by governments in most developed countries. A lack of liquidity can be remedied by raising deposit rates and effectively marketing deposit products. However, an important measure of a bank's value and success is the cost of liquidity. A bank can attract significant liquid funds. Lower costs generate stronger profits, more stability, and more confidence among depositors, investors, and regulators. One of the most important tasks faced by the management of any bank is ensuring adequate liquidity. A bank is considered to be liquid if it has already access to immediately spendable funds at reasonable cost at precisely the time those funds are needed. This suggests that a liquid bank either has the right amount of immediately spendable funds on hand when they are required or can quickly raise liquid funds by borrowing or by selling assets. Lack of adequate liquidity is often one of the first sign that a bank is in serious financial trouble the troubled banks usually begins to loss deposits, which erodes its supply of cash and forces the institution to dispose of its more liquid assets. Other banks become increasingly reluctant to lend the troubled bank any

funds without additional security or a higher rate of interest, which further reduces the earning of problem institution and threatens it with failure. Many banks assume that liquid funds can be borrowed virtually without limit any time they are needed. Therefore, they see little need to store liquidity in the form of easily marketed, stable price assets. The enormous cash shortages experienced in recent years by banks in trouble make clear that liquidity needs can t be ignored. Liquidity management is for more important than we may realize, because a bank can be closed if it cannot raise enough liquidity even though, technically, it may still be solvent. Moreover, the competence of a bank s liquidity managers is an important barometer of management s overall effectiveness in achieving the bank s goals.

The demand for and supply of bank liquidity:

A bank s need for liquidity immediately spendable funds can be viewed within a supply and demand frame work. What activities give rise to the demand for liquidity inside a bank? And what sources can the bank rely upon to supply liquidity when spendable funds are needed? For most banks, the most pressing demands for spendable funds come from two sources;  Customers withdrawing money from their deposits, and  Credit requests from customers the bank wishes to keep, either in the form of new loan requests, renewals of expiring loan agreements, or drawings upon existing credit line. Other sources of liquidity of demand include paying off obligation arising from bank borrowings, such as loans the bank may have received from other banks or from the Central Bank. Similarly, payment of income taxes or cash dividends to the bank s stockholders periodically gives raise to a demand for immediately spendable cash. To meet the forgoing demands for liquidity, banks can draw upon several potential sources of supply. The most important source normally is receipt of new customer deposits, both from newly opened accounts and from new deposits

placed in existing accounts. These deposit inflows are heavy the first of each month as business payroll are dispensed, and they may reach a secondary peak toward the middle of each month as bills are paid and other payrolls are met. Another important element in the supply of bank liquidity comes from customers repaying their loans, which provides fresh funds for meeting new liquidity needs, as do sale of bank assets, especially marketable securities, from the bank s investment portfolio. Liquidity also flows in from revenues generated by selling nondeposit services and from borrowings in the money market.

Why bank face significant liquidity problem

It should be clear from the forgoing discussion that banks face major liquidity problems. The significant exposure of banks to liquidity pressures arises from several sources. First, banks borrow large amounts of short term deposits and reserves from individual and businesses and from other lending institutions and then turn around and make long term credit available to their borrowing customers. Thus, most banks face some imbalances between the maturity dates on their assets and the maturity dates attached to their liabilities. Rarely will incoming cash flows from assets exactly balance cash flowing out to cover liabilities. A problem related to the mismatch situation is that banks hold an unusually high proportion of liability subject to immediate payment, such as demand deposits, and money market borrowings. Thus, banks must always stand ready to meet immediate cash demands that can be substantial at times, especially near the end of week, at the first of each month, and during certain seasons of the year. Another source of liquidity problems is the bank s sensitivity to changes in interest rates. When interest rates rise, some depositors will withdraw their funds in search of higher returns elsewhere. Many loan customers may postpone new loan requests or speed up there drawings on those credit lines that carry lower interest rates. Thus, changing interest rates affect both customer demand for deposits and customer demand for loans, each of which has a potent impact on

bank s liquidity position. Moreover, movements in interest rates affect the market values of assets the bank may need to sell in order to raise additional liquid funds, and they directly affect the cost of borrowing in the money market. Beyond these factors, a bank must give high priority to meeting demands for liquidity. To fail in this area may severely damage public confidence in the institution. We can imagine the reaction of bank customers if the teller windows and teller machines had to be closed one morning because the bank was temporarily out of cash and could not cash checks or meet deposits withdrawals. One of the most important tasks of a bank s liquidity manager is to keep close contact with the bank s largest depositors and holders of large unused credit lines to determine if and when withdrawals of funds will be made and to make sure adequate funds are available.

Strategies for liquidity managers

Over the years, experienced liquidity managers have developed several broad strategies for dealing with bank liquidity problems:  Providing liquidity from assets  Relying on borrowed liquidity to meet cash demands  Balanced liquidity management

Asset liquidity management (or asset conversion) strategies

The oldest approach to meeting bank liquidity needs is known as asset liquidity management. In its purest form, this strategy calls for storing liquidity in the form of holdings of liquid assets, predominantly in cash and marketable securities. When liquidity is needed, selected assets are sold for cash until all bank s demands for cash are met. This liquidity management strategy is often called conversion because liquid funds are raised by converting noncash assets into cash.

What is liquid asset? It must have three characteristics:  A liquid asset must have a ready market so that it can be converted into cash without delay.  It must have a reasonably stable price so that, no matter how quickly the asset must be sold or how large the sale is, the market is deep enough to absorb the sale without a significant decline in price.  It must be reversible so that the seller can recover his/her original investment (principal) with little risk of loss. Among the most popular liquid assets for banks are treasury bills, federal funds loan, deposits held with other banks, municipal bonds, federal agency securities, banker s acceptances. Although a bank can strengthen its liquidity position by holding more liquid assets, it will not necessarily be a liquid institution if it does so, because a bank s liquidity position is also influenced by the demands for liquidity made against it. Remember: a bank is liquid only if it has access, at reasonable cost, to liquid funds in exactly the amounts required at the time they are needed. Asset liquidity management strategy is used mainly by smaller banks that find it a less risky approach to liquidity management than relying on borrowings. But asset conversion is not a cost-less approach to liquidity management. First, selling assets means the bank losses the future earnings those assets would have generated had they not been sold off. Thus, there is an opportunity cost (potential loss of future bank earnings due to the sale of income generating bank assets in order to raise cash(liquidity)) to storing liquidity in assets when those assets must be sold. Most asset sales also involve transactions costs (commission) paid to security brokers. Moreover, the assets in questions may need to be sold in a market experiencing declining prices, subjecting to the risk of substantial capital looses. Management must take care that those assets with the least profit potential are sold first in order to minimize the opportunity cost of future earnings forgone. Selling assets to raise liquidity also tends to weaken the appearance of the bank s balance

sheet, because the assets sold are often low-risk government securities that give the impression the bank is financially strong. Finally, liquid assets generally carry the lowest rates of return of all financial assets. Bankers investing heavily in liquid assets must forgo higher returns on other assets they would prefer to acquire if they did not have to be so well prepared for liquidity demands.

Borrowed liquidity (liability) management strategies

In 1960s and 1970s, many banks, led by the largest in the industry, began to raise more of their liquid funs through borrowings in the money market. This borrowed liquidity strategy often called purchased liquidity or liability management-in its purest from calls for borrowing enough immediately spendable funds to cover all anticipated demands for liquidity. Borrowing liquid funds has a number of advantages. A bank can choose to borrow only bank it actually needs funds, unlike storing liquidity in asset where a storehouse of at least some liquid assets must be held at all times, lowering the bank s potential return because liquid assets usually have such low yields. Then, too, using borrowed funs permits a bank to leave the volume and composition of its assets portfolio unchanged if it satisfied with the assets it currently holds. In contrast, selling assets to provide liquidity shrinks the size of a bank as its total asset holdings decline. Finally, liability management comes with its on control lever the interest rate offered to borrow funds. If the borrowing bank needs more funds, it merely raises its offer rate until the requisite amount of funds flow in. if fewer funds are required the bank s offer rate may be lowered. The principal sources of borrowed liquidity for a bank include large ($100,000+) negotiable CDs, federal funds borrowings, repurchase agreements (in which securities are sold temporarily with an agreement to buy them back), and borrowings at the discount window of the central bank in each nation or region. Liability management techniques are used most extensively by the largest banks, which often borrow close to 100 percent of their liquidity needs.

Borrowing liquidity is the most risky approach to solving bank liquidity problems (but also has the highest expected return) because of the volatility of money market interest rates and the rapidly with which the availability of credit can change. Often banks must purchase liquidity when it is most difficult to do so, both in cost and in availability. The bank s borrowing cost is always uncertain, which adds greater uncertainty to the bank s net earnings. Moreover, a bank that gets into financial trouble is usually most in need of borrowed liquidity, particularly because knowledge of the bank s difficulties spreads and depositors begin to withdraw their funds, at the same time, other financial institutions become less willing to lend to the troubled bank due to the risk involved. Balanced (asset and liability) liquidity management strategies: Due to the risks inherent in relying on borrowed liquidity and the costs of storing liquidity in assets. Most banks compromise in choosing their liquidity management strategy and use both asset management and liability management. Under a balanced liquidity management strategy some of the expected demands for liquidity are stored in assets (principally holdings of marketable securities and deposits at other banks), while other anticipated liquidity needs are backstopped by advance arrangements for lines of credit from correspondent banks or other suppliers of funds. Unexpected cash needs are typically met from near-term borrowings. Longer-term liquidity needs can be planned for and funds to meet them parked in short-term and mediumterm loans and securities that will roll over into cash as those liquidity needs arise.

Liquidity Indicator Approach

Many banks estimate their liquidity needs based on experience and industry averages. This often means certain bellwether financial ratios or liquidity indicators. For example:          Cash position indicator Liquid securities indicator Net federal funds position Capacity ratio Pledged securities ratio Hot money ratio Deposit brokerage index Core deposit ratio Deposit composition ratio

Cash position indicator

Cash and deposits due from depository institutions/total assets, where a greater proportion of cash implies the bank is in a stronger position to handle immediate cash needs.

Liquid securities indicator

Government securities/total assets, which compares the most marketable securities a bank can hold with overall size of its assets portfolio, the greater the proportion of government securities , the more liquid the bank portion tends to be.

Net federal funds position

(Federal funs sold-federal funs purchased)/total assets, which measures the comparative importance of overnight loans (federal funds sold) to overnight borrowings of reserves (federal funds purchased), liquidity tends to increase when this ratio rises.

Capacity ratio
Net loans and leases/total assets, which is really a negative liquidity indicator because loans and leases are often among the most illiquid assets a bank can hold.

Pledged securities ratio

Pledged securities/total security holdings, also a negative liquidity indicator because the greater the proportion of securities pledged to back government deposits, the fewer securities are available to sell when liquidity needs arise.

Hot money ratio

Money market assets/ money market liabilities , this is a ratio that reflects whether the bank has balanced its borrowings in the money market with the increase in its money market assets that could be sold quickly to cover those money market liabilities.

Deposit brokerage index

Brokered deposits/ total deposits, where brokered deposits consist of packages of funds (usually $100,000 or less to gain the advantage of deposit insurance) placed by securities brokers for their customers with banks paying the highest yields. Brokered deposits are highly interest sensitive and may be quickly withdrawn, the more the banks holds, the greater the chance of a liquidity crises.

Core deposit ratio

Core deposits/total assets, where core deposits are defined as total deposits less all deposits over $100,000. Core deposits are primarily smalldenomination accounts from local customers that are considered unlikely to b withdrawn on short notice and so carry lower liquidity requirements.

Deposit composition ratio

Demand deposits/time deposits, where demand deposits are subject to immediate withdrawal via check writing, while time deposits have fixed maturities with penalties for early withdrawal. This ratio measures how stable a funding base each bank possesses, a decline in the ratio suggests greater deposit stability and, therefore, a lessened need for liquidity. The first five liquidity indicators focus principally upon asset or stored liquidity. The last four focus mainly on a bank s liabilities, or purchased liquidity. If most indicators seem to show a gradual decline in bank liquidity, particularly in liquid assets, one reason is a gradual shift in bank deposits toward longer-maturity instruments that are more stable and have fewer unexpected withdrawals. Another important factor is decline in deposit reserves banks need to hold. There are also more ways to raise liquidity today, and advancing technology has made it easier to anticipate bank liquidity needs and to prepare for them. The Ultimate Standard for Assessing Liquidity Management (Signals from Market Place): Many financial analysts believe there is one ultimate method for assessing a bank s liquidity needs and how well it is fulfilling them. This method centers on the discipline of the financial marketplace. For example, consider this question: Does a bank really hold adequate liquidity reserves? The answer depends upon the bank s standing in the market. No bank can tell for sure if it has sufficient liquidity until it has passed the market s test. Specifically, management should look at these signals:

     

Public confidence Stock price behavior Risk premium on CDs and other borrowings Loss sales of assets Meeting commitments to credit customers Borrowings from the Central Bank

Public confidence
Is there evidence the bank is losing deposits because individual and institutions believe there is some danger it will run out of cash and be unable to pay its obligations?

Stock price behavior

Is the bank s stock price falling because investors perceive the bank has an actual or pending liquidity crisis?

Risk premium on CDs and other borrowings

Is there evidence that the bank is paying significantly higher interest rates on its offerings of time and savings deposits (especially on large negotiable CDs) and money market borrowings than other banks of similar size and location? In other words, is the market imposing a risk premium in form of higher borrowing costs because it believes the bank is headed fir a liquidity crisis?

Loss sales of assets

Has the bank recently been forced to sell assets in a hurry, with significantly losses, in order to meet demands for liquidity? Is this a rare event or has it become a frequent occurrence?

Meeting commitments to credit customers

Has the bank been able to honor all reasonable and potentially profitable requests for loans from its valued customers? Or have liquidity pressure compelled management to turn down some otherwise acceptable loan application?

Borrowings from the Central Bank

Has the bank been forced to borrow in larger volume and more frequently from the Central Bank in its home territory lately? Have Central Bank officials begun to question the bank s borrowings? If the answer to any of these questions is yes, management needs to take a close look at its liquidity management policies and practices to determine whether changes are in order.