1 Calculate ROA 2 Calculate ROE 3 Types of Risk Embedded in investment securities P 329 Prepayment Risk Credit Default Risk A form of risk specific to asset backed securities such Interest Rate Risk The probability that rising or falling interest rates will adversely effect the margin of interest revenues over interest expenses or result in decreasing the value of net worth Rising interest rates lower the market value of previously issued bonds and notes with longer term issues suffering the greatest losses The probability that the issuer of a loan or security will fail and default on any promised payments of interest or principal or both The risk of default has led to regulatory controls that prohibit the acquisition of speculative securities securities rated below Baa by Moody s or BBB on S P as CMOs and GNMA or FNMA pass throughs It arises when some of the previous mentioned securitized assets are paid off early and the investor receiving those prepayments may be forced to reinvest the prepaid funds at lower current market yields resulting in a lower than expected overall return from investing in securitized assets Inflation Risk including the interest rate on borrowed funds and the cost of personnel and other productive resources will rise or that the value of assets will be eroded due to rising prices lowering the expected return on invested capital Purchasing power Protection against inflation risk is provided by short term securities and those with variable interest rates into a recession with reduced demand for loans deposits and other products and services The probability that an individual or institution will be unable to raise cash precisely when cash is needed at reasonable cost and in the volume required The danger that the investor will receive a lower rate of return because the issuer called the security or bond before it reached maturity The probability that the prices of goods and services The risk that the economy will turn down Business Liquidity Call Risk 4 Impact of Profitability margins on a bank P 172 breaking down profitability measures into their respective components tells us much about the causes of earnings difficulties and suggests where management needs to look for possible cures for any earnings problems that surface Achieving these profits depend upon several crucial factors 1 Careful use of financial leverage 2 Careful use of operating leverage from fixed assets 3 Careful control of operating expenses so that more dollars of sales revenue become net income 4 Careful management of the asset portfolio to meet liquidity needs while seeking the highest returns from any assets acquired 5 Careful control of exposure to risk so that losses don t overwhelm income and equity capital Net Income Revenues NPM 5 Types of bank assets liabilities P 223 and Possibly P 220 repriceable and nonrepriceable shit or P 132 Assets Cash and deposits owned Marketable securities Business loans Real estate loans Consumer Loans Farm loans Buildings and Equipment Checkable deposits savings accounts Money market deposits long term time deposits short term borrowings Liabilities 6 Shape of Yield Curve P 216 Despite the fact that Yield curves are constantly changing shape because the yields of the financial instruments included in each curve change every day a yield curve will display Upward Downward or Horizontal slope Yield curves will display an upward slope when long term interest rates A yield curve will slope downward when short term interest rates higher exceed short term interest rates than long term rates Yield curves are horizontal when long term interest rates and short term interest rates are approximately at the same level so that investors receive the same yield to maturity no matter what maturity of investment security they purchase 7 Calculate Yield to Maturity Calculators exist for a reason However Coupon rate x Par PMT divide PMT in half and Double N if interest is paid semiannually P Y 2 Looking for YTM I Y N Periods FV Par 1k PV Current price 8 Components of asset liability sensitive banks P 219 and possibly read P 221 Protecting against interest rate changes no matter which way they move by making sure for each time period that the Dollar amount of repriceable interest sensitive assets Dollar amount of repriceable interest sensitive liabilities When referring to an asset or liability as repriceable or interest sensitive it means that that item can be repriced as market interest rates change The most familiar examples of interest sensitive assets are loans that are about to mature or are coming up for renewal A common example of an interest sensitive liability is a depository institutions certificate of deposit CD that is about to mature or be renewed IS Assets don t equal IS Liabilities a gap exists and that gap is the portion of the balance sheet that is affected by interest rate risk To be considered asset sensitive and have a positive gap IS assets IS To be considered liability sensitive and have a negative gap IS assets IS Liabilities 0 liabilities 0 9 Influences of Duration on a bond Duration a value and time weighted measure of maturity that considers the timing of all cash inflows from earning assets and all cash outflows associated with liabilities Duration measures the average time needed to recover the funds committed to an investment and the average maturity of a promised stream of future cash flows Using Duration and its relationship market interest rates and investment security prices we can see how sensitive an investment security s market price will be to changes in market interest rates and we can decide whether the security we are interest in is too price sensitive or possibly not PS enough Duration in relation to bonds specifically is a measurement of how long in years it takes for the price of a bond to be repaid by its internal cash flows It is an important measure for investors to consider as bonds with higher durations bonds with lower durations and have higher price carry more risk volatility than 10 Advantages disadvantages of futures forwards P 252 253 Shifts risk of interest rate fluctuations from risk averse investors such as banks and insurance companies to speculators willing to accept and possibly profit from such risks Less risky investment than Forwards because the exchange guarantees the settlement of each contract if one side defaults An exchange provides a substantial number of speculators and specialists on each exchange
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