Commercial Banks, Mutual Funds, and Hedge Funds
Bank Sources of Funds
Deposit Accounts
Transaction Deposits: Demand deposit accounts or checking accounts allow customers to write checks.
Savings Deposits: Traditional passbook savings accounts do not permit check writing.
Time Deposits: Deposits that cannot be withdrawn until a specified maturity date.
Money Market Deposit Accounts: Offer limited check-writing, require larger minimum balances, and provide higher yields.
Borrowed Funds
Federal Funds Purchased: Used by banks to correct short-term fund imbalances.
Borrowing from the Federal Reserve Banks: Primarily used to resolve temporary fund shortages.
Repurchase Agreements
Long-Term Sources of Funds
Bonds Issued by the Bank: Banks finance fixed assets (land, buildings, equipment) with long-term sources like bond issuance.
Bank Capital: Funds acquired through stock issuance or retained earnings.
Smaller banks rely more on savings deposits, while larger banks depend more on short-term borrowings.
Bank Uses of Funds
Cash: Banks hold cash reserves to meet Federal Reserve requirements.
Bank Loans
Investment in Securities
Treasury and Agency Securities
Corporate and Municipal Bonds
Mortgage-Backed Securities
Federal Funds Sold
Repurchase Agreements
Fixed Assets
Smaller banks tend to have more household loans and government securities; larger banks have more business loans (including to foreign firms).
Off-Balance Sheet Activities
Loan Commitments: Bank obligation to provide a specified loan amount to a firm upon request.
Standby Letters of Credit: Bank backs a customer’s obligation to a third party.
Forward Contracts on Currencies: Agreement between a customer and a bank to exchange currencies on a future date at a specified rate.
Interest Rate Swap Contracts: Two parties exchange interest payments on a notional principal amount; the bank receives a transaction fee.
Credit Default Swap Contracts: Protect investors against default risk on debt securities.
Key Risks Banks Should Manage
Liquidity Risk: Inability to meet short-term financial obligations due to asset-liability imbalance.
Mitigation: Maintain cash reserves and access to funding sources.
Interest Rate Risk: Changes in interest rates adversely affecting bank profitability or asset/liability values.
Mitigation: Use hedging strategies like derivatives.
Credit Risk: Loss due to borrower’s failure to repay loans.
Mitigation: Conduct credit assessments, diversify loan portfolios, and maintain loan loss reserves.
Market Risk: Losses due to changes in market prices (stocks, commodities, exchange rates).
Mitigation: Use risk models, diversify investments, and implement hedging strategies.
Managing Liquidity
Management of Liabilities: Resolve cash deficiencies by creating liabilities or selling assets.
The marketability of assets affects liquidity.
Management of Money Market Securities: Invest funds in short-term Treasury or money market securities.
Banks must balance liquidity with achieving a reasonable return on assets.
Management of Loans: Secondary market improves loan liquidity, but liquidity may decrease during economic downturns.
Use of Securitization to Boost Liquidity: MBS or Collateralized Loan Obligations.
Managing Interest Rate Risk
Net Interest Margin (NIM): Difference between interest payments received and interest paid.
During rising interest rates, NIM decreases if liabilities are more rate-sensitive than assets.
Sensitivity depends on deposit turnover rate.
Banks assess risk and use future interest rate forecasts to decide whether and how to hedge.
Impact of Increasing VS Decreasing Interest Rates on a Bank’s Net Interest Margin
Assuming that the Bank’s Liabilities are More Sensitive Than Its Assets
Methods Used to Assess Interest Rate Risk
Gap Analysis: Monitor the gap between rate-sensitive assets and liabilities.
Gap Ratio: Volume of rate-sensitive assets divided by rate-sensitive liabilities.
Duration Gap Analysis
= Weighted average duration of the bank’s assets
= Weighted average duration of the bank’s liabilities
= Market value of the bank’s assets
= Market value of the bank’s liabilities
Methods Used to Assess Interest Rate Risk (cont.)
Regression Analysis: Determine how performance has been historically influenced by interest rate movements.
Requires identifying proxies for bank performance and prevailing interest rates, and selecting a model to estimate their relationship.
Methods Used to Reduce Interest Rate Risk
Maturity Matching: Match each deposit’s maturity with an asset of the same maturity.
Using Floating-Rate Loans: Support long-term assets with short-term deposits.
Using Interest Rate Futures Contracts: Lock in the price at which financial instruments can be purchased or sold on a specified future settlement date.
Financial futures contracts can reduce the uncertainty about a bank’s net interest margin.
Using Interest Rate Swaps: Exchange periodic cash flows based on specified interest rates.
Using Interest Rate Caps: Receive payments when the interest rate of a security or index rises above a specified level.
During rising interest rates, the cap provides compensation that can offset the reduction in spread during such periods.
Introduction to Mutual Funds
Key financial intermediaries that pool funds from investors to purchase securities.
Serve as a mechanism for diversifying individual investments.
Individual investors and institutions can turn over the selection and management of their investment portfolio to a third party instead of assembling a portfolio on their own.
Pricing Shares of the Mutual Fund
Net Asset Value (NAV): The price per share is equal to the NAV, which represents the value of the fund's portfolio per share, after deducting management expenses.
Dividend Impact: When a mutual fund pays dividends, its NAV decreases by the dividend amount per share.
Example:
Suppose an investment firm wants to start a mutual fund with a target of US\$10 million.
The firm can raise this amount through investments from five individuals and two institutions.
Mutual Fund: NAV Example
Fund Setup: The total fund value is US\$10 million (Net Asset Value or NAV). The firm issues 100,000 shares at an initial value of US\$100 per share (US\$10 million / 100,000 shares = US\$100).
Investment Management: A portfolio manager is appointed to manage the US\$10 million invested across various securities.
Future NAV Changes: The NAV will fluctuate based on the performance and value of the fund’s portfolio assets.
Open-End vs Close-End Funds
Open-End Funds: Accept new investments and issue additional shares based on the current net asset value (NAV).
Assume the NAV of the fund increases to US\$12 million with an NAV per share of US\$120.
A new investor, F, invests US\$0.96 million. At the new NAV of US\$120 per share, the fund would create 8,000 shares (US\$0.96 million / US\$120).
After this investment, the fund's total value would increase to US\$12.96 million, with 108,000 shares in total.
Withdrawals in Open-End Funds: Funds can be withdrawn at the net asset value (NAV) per share. For example, if Investor E wishes to withdraw all her shares, the fund needs to liquidate US\$0.6 million to retire 5,000 shares (at US\$120 per share).
Closed-End Funds:
In a closed-end fund, no new investments are accepted into the fund.
New investors buy existing shares, and current investors sell their shares to others.
The number of outstanding shares remains fixed.
Key Difference: Unlike open-end funds, where shares are created or redeemed at NAV, closed-end funds can trade at a premium or discount to the NAV depending on market demand.
Open-End vs Close-End Funds Cont.
Advantages and Disadvantages:
Open-End Funds:
Easy to grow but creates pressure on portfolio managers to manage cash inflows and outflows effectively.
Need to liquidate assets, which might not be desirable, to meet redemption requests.
New investments are needed to cover redemptions, leading to the fund holding some cash instead of being fully invested.
Closed-End Funds:
Do not face the same challenges as open-end funds but have a limited ability to grow.
As of 2017, only 1% of the total net asset value of all US mutual funds (US\$19 trillion) were in closed-end funds.
TYPE OF MUTUAL FUNDS
Money Market Funds
Money market funds invest in short-term instruments like Treasury bills, certificates of deposit, and commercial paper.
These funds aim to provide security of principal, high liquidity, and returns aligned with money market rates.
Many funds operate on a constant net asset value (CNAV) basis, typically maintaining a share price of $1 (or the equivalent in local currency).
Types of Money Market Funds:
Taxable Funds: Invest in high-quality corporate debt and federal government debt.
Tax-Free Funds: Invest in short-term state and local government debt, offering tax advantages.
TYPE OF MUTUAL FUNDS Cont.
Bond Mutual Funds
A bond mutual fund consists of a portfolio of individual bonds and sometimes preferred shares.
Net Asset Value (NAV): The NAV is calculated by summing the value of each bond in the portfolio and dividing by the number of shares.
Investors: Investors hold shares in the fund, representing their pro-rata share or interest in the portfolio.
Key Difference: The main difference between a bond mutual fund and a money market fund is the maturity of the underlying assets.
Money market funds: Typically invest in assets maturing in less than 90 days.
Bond mutual funds: Can invest in bonds with maturities ranging from 1 year to 30 years or more.
Stock Mutual Funds
Actively Managed Funds: The portfolio manager selects stocks with the goal of outperforming the market.
Index Funds (Passive Management): Aims to replicate the performance of a specific market index, rather than trying to outperform it. The first index fund was introduced in 1976 by the Vanguard Group.
Differences Between Actively Managed and Index Funds:
Management Fees: Actively managed funds have higher fees due to the cost of selecting stocks and research, while Index funds have lower fees since they simply track an index.
Level of Trading: Actively Managed Funds tend to trade more frequently, which can trigger higher capital gains taxes. However Index Funds follow a buy-and-hold strategy, resulting in fewer taxable events.
Hybrid/Balanced Funds
Hybrid or balanced funds invest in both bonds and stocks.
These funds are less common in the US but are popular in Europe.
Recently, they have gained popularity with the growth of lifecycle funds, also known as Target Date Funds.
These funds automatically adjust the asset mix based on the investor's desired retirement date.
Expenses Incurred by Mutual Fund Shareholders
Mutual funds pass their expenses to shareholders.
The expenses include compensation to the portfolio managers and other employees, research support, recordkeeping and clerical fees, and marketing fees.
Sales Charge: Mutual funds may be referred to as either as a load fund or a no -load fund.
12b-1 Fees: Some mutual funds charge shareholders a 12b-l fee (in reference to SEC rule 12b-l) as part of the fund’s annual expenses to cover administrative or marketing expenses.
Hedge Funds
Hedge funds are private investment vehicles that often use leverage, derivatives, and long-short strategies.
Origin: Traced back to 1949 with A.W. Jones & Co. offering a strategy to offset the typical "long-only" position.
As of May 2017, hedge fund assets totaled US\$3.3 trillion globally.
Investment Strategies:
Hedge funds use a range of strategies from niche approaches (e.g., long-short financial services) to global multi- strategy approaches.
They are commonly used for portfolio diversification.
Key Characteristics:
Short Selling: Many hedge funds short positions using derivatives like options, futures, and credit default swaps.
Absolute Return Seeking: Hedge funds aim for positive returns in all market environments.
Leverage: Use of financial leverage (bank borrowing) or implicit leverage (using derivatives) to increase investment capacity.
Low Correlation: Hedge funds typically show low return correlations with traditional equity and fixed-income asset classes
Hedge Funds - Fee structures
Types of Fees:
Asset-Based Management Fee (AUM Fee): Charged as a percentage of assets under management.
Incentive (Performance) Fee: A portion of the fund's realized capital gains, typically up to 20%.
Traditional Fee Structure:
Management Fees: Historically 2% of the assets.
Incentive Fees: Typically up to 20% of profits, though there has been downward pressure due to increased competition and more alternative products.
Investor Accessibility:
Hedge funds are generally not readily available to all investors.
They typically require a high minimum investment and often have restricted liquidity (e.g., quarterly withdrawals or long-term commitment
Fee structures-Example
You invested US\$10 million in a hedge fund with the following terms:
Management fee: 2% per year, based on the total assets under management (AUM).
Incentive (performance) fee: 20% of the capital gains at the end of the year.
Performance of the fund:
At the end of Year 1, the fund appreciates by 8% in value.
At the end of Year 2, the fund depreciates by 4% in value.
Part A: Calculate the management fee and incentive fee at the end of Year 1 and Year 2.
Part B: What is the total value of your investment at the end of Year 2, after accounting for the management fee, incentive fee, and the price changes?
Solution
End of Year 1:
Initial investment = US$10 million
Fund appreciation = 8%
Value at the end of Year 1 (before fees) =
The management fee is based on the end-of-year value:
Management Fee Year 1=
Value After Management Fee (Year 1):
Incentive Fee (Year 1): The capital gain is calculated after the management fee has been deducted.
Capital Gain Year 1=
The incentive fee is 20% of the capital gain:
Incentive Fee Year 1 =
Value After Incentive Fee (Year 1):
End of Year 2:
Value at the end of Year 1 = US\$10,467,200 & Fund depreciation = 4%
Value at the end of Year 2 (before fees) =
Management Fee (Year 2): The management fee is based on the end-of-year value:
Management Fee Year 2 =
Value After Management Fee (Year 2):
Incentive Fee (Year 2): Since the fund has experienced a capital loss in Year 2, there will be no incentive fee.
Capital Gain/Loss Year 2 = (Loss)
Hedge Fund Strategies
Equity-related hedge fund strategies focus primarily on the equity markets, and the majority of their risk profiles involve equity-oriented risk.
Event-driven hedge fund strategies focus on corporate events, such as governance events, mergers and acquisitions, bankruptcy, and other key events for corporations.
Relative value hedge fund strategies focus on the relative valuation between two or more securities.
Opportunistic hedge fund strategies take a top-down approach, focusing on a multi-asset (often macro-oriented) opportunity set.
Specialist hedge fund strategies focus on special or niche opportunities that often require a specialized skill or knowledge of a specific market.
Equity-related hedge fund strategies
Long/Short Equity
Long/Short Equity (L/S) managers buy stocks they expect to rise (long positions) and sell stocks they expect to fall (short positions).
Mandates and Strategy:
Long/short strategies can shift based on industry sectors (e.g., technology to consumer goods) and geographic regions (e.g., Europe to Asia).
Managers focus heavily on fundamental research to guide their decisions.
Exposure and Risk:
40%-60% long (buying undervalued companies).
20%-50% short (selling overvalued companies).
Strategy aims to reduce risk by having returns similar to long-only strategies but with a 50% lower standard deviation (lower volatility).
Attractiveness:
Liquidity: Easily tradable in public markets.
Diversification: Reduces risk by balancing long and short positions.
Additional Benefits: Potential for alpha (excess returns) and reduced portfolio volatility due to short positions.
Dedicated Short Selling and Short–Biased
* Dedicated Short Selling:
* Hedge fund managers take short-only positions in equities that are expensively priced compared to their deteriorating fundamentals.
* They may vary their short exposure levels and hold higher levels of cash at times for risk management.
* Short-Biased Strategies:
* These managers focus on shorting expensive equities but may balance the short positions with some long exposure, typically in value or index-based stocks.
* Goal: To identify overvalued stocks using fundamental analysis, including factors like fraudulent accounting or corporate mismanagement.
* Exposure:
* Dedicated short sellers: Typically 60%-120% short.
* Short-biased managers: Typically around 30%-60% net short.
* Attractiveness:
* Liquidity: Liquid assets, with negatively correlated returns to other strategies.
* Alpha Generation: Potential to generate uncorrelated alpha, although historical returns have often been disappointing and volatile.Equity Market Neutral
Equity Market Neutral (EMN) hedge fund strategies involve taking opposite positions (long and short) in related equities with divergent valuations.
The goal is to maintain a near net-zero portfolio exposure to the market, meaning the market risk (beta) is neutralized.
Managers design portfolios so that the expected portfolio beta is approximately zero, minimizing exposure to market movements.
Characteristics:
Modest Returns: EMN strategies typically generate modest returns.
High Diversification & Liquidity: These strategies have high levels of diversification and liquidity.
Lower Standard Deviation: They tend to have lower volatility (standard deviation of returns) compared to other strategies in normal market conditions.
Attractiveness:
Idiosyncratic Opportunities: EMN strategies capitalize on short-term mispricing between related securities.
Alpha Generation: They seek alpha (excess returns) by exploiting mispricing without assuming market risk (beta).
Ideal for Market Weakness: Especially attractive during periods of market vulnerability or weakness, as they do not require exposure to broad market movements.
Event-driven hedge fund strategies
Merger Arbitrage
* Merger Arbitrage involves taking advantage of price discrepancies during mergers and acquisitions (M&A).
* Mergers and acquisitions can be classified as either cash-for-stock or stock-for-stock purchases.
* Cash-for-Stock Acquisition: In a cash-for-stock deal, the acquiring company (A) offers a cash price per share to acquire the target company (T).
* Stock-for-Stock Acquisition: In a stock-for-stock deal, A offers its own shares in exchange for shares in T.
* Attractiveness:
* Merger arbitrage typically offers relatively high Sharpe ratios, with double-digit returns and low to mid-single-digit standard deviation.
* The strategy aims for steady returns but involves lower-tail risk (risk of losses if the merger fails).Distressed securities
* Distressed securities strategies focus on companies facing financial stress, bankruptcy, or potential bankruptcy.
* Reasons for distress include excessive leverage, poor governance, accounting issues, or fraud.
* Distressed companies' securities may be trading at a discount due to the company’s financial difficulties but can recover if managed properly.
* Hedge Fund Advantage:
* Hedge funds are not constrained by minimum credit quality standards, allowing them to invest in distressed securities where institutional investors may avoid.
* They also offer periodic liquidity (e.g., quarterly or annually), making the illiquid nature of distressed securities easier to manage compared to mutual funds.
* Risk and Return: High Returns and High Volatility: Distressed securities can yield high returns but come with significant risk due to the volatility of the companies involved.
* Attractiveness:
* Cyclical Returns: Returns tend to be lumpy and cyclical, often tied to economic recovery phases.
* Appeal in Market Dislocation: Particularly attractive during the early stages of economic recovery after a period of market dislocation.Example: Merger Arbitrage Strategy Payoffs
* An acquiring firm (A) is trading at $45/share and has offered to buy target firm (T) in a stock-for-stock deal. The offer ratio is 1 share of A in exchange for 2 shares of T.
* Target firm T was trading at $15 per share just prior to the announcement of the offer.
* Shortly thereafter, T’s share price jumps up to $19 while A’s share price falls to $42 in anticipation of the merger receiving required approvals and the deal closing successfully.
* A hedge fund manager is confident this deal will be completed, so he buys 20,000 shares of T and sells short 10,000 shares of A. What are the payoffs of the merger arbitrage strategy if the deal is successfully completed or if the merger fails?Solution: Merger Arbitrage Strategy Payoffs
* At current prices it costs $380,000 to buy 20,000 shares of T, and $420,000 would be received for short selling 10,000 shares of A. This provides a net spread of $40,000 to the hedge fund manager if the merger is successfully completed.
* If the merger fails, then prices should revert to their pre-merger announcement levels. The manager would need to buy back 10,000 shares of A at $45 (costing $450,000) to close the short position, while the long position in 20,000 shares of T would fall to $15 per share (value at $300,000). This would cause a total loss of: $110,000 [= (A: +$420,000 – $450,000) + (T: –$380,000 + $300,000)].
Relative value hedge fund strategies
Fixed-Income Arbitrage
* Fixed-income arbitrage involves taking long and short positions in different debt securities to exploit pricing inefficiencies.
* Debt securities can include:
* Sovereign and corporate bonds
* Bank loans and consumer debt (e.g., credit card loans, student loans, mortgage-backed securities).
* Arbitrage opportunities arise due to variations in: Duration, Credit quality, Liquidity, Optionality
* Convertible Bonds Arbitrage: Convertible Bonds are hybrid securities that combine the features of straight debt and a long equity call option.
* Attractiveness: Profitable when there are mispricing opportunities between the convertible bond price and the underlying stock price.Example: Convertible Arbitrage Strategy
* Cleopatra Partners is a Dubai-based hedge fund engaging in convertible bond arbitrage.
* Portfolio manager Shamsa Khan is considering a trade involving the euro-denominated convertible bonds and stock of QXR Corporation.
* She has assembled the following information:
* QXR Convertible Bond Price (% of par): 120
* Coupon (%): 5.0
* Remaining maturity (years): 1.0
* Conversion ratio: 50
* QXR Stock: $30 per share
* What is the basic trade setup that Khan should implement for arbitrage? What is the potential profits earned if QXR’s share price falls to €24, rises to €36, or remains flat at €30? (do not consider coupon payment for simplicity)Solution: Convertible Arbitrage Strategy
* QXR’s convertible bond price is €1,200 [= €1,000 × (120/100)], and its con- version ratio is 50; so, the conversion price is €24 (€1,200/50). This compares with QXR’s current share price of €30.
* It can be concluded that in relative terms, QXR’s shares are overvalued and its convertible bonds are undervalued. Thus, Khan should buy the convertibles and short sell the shares.
* By implementing this trade and buying the bond at €1,200, exercising the bond’s conversion option, and selling her shares at the current market price, Khan can lock in a profit of €6 per share under any of the scenarios mentioned, as shown in the following table:
| QXR Share Price | Long Stock via Convertible Bond | Short Stock | Total Profit |
|-----------------------|----------------------------------------|----------------|---------------|
| 24 | 0 | 6 | 6 |
| 36 | 12 | -6 | 6 |
| 30 | 6 | 0 | 6 |
Opportunistic hedge fund strategies
Global Macro Strategies
* Global macro managers use both fundamental and technical analysis to value markets.
* Strategy Types:
* Directional Strategies:
* Example: Buy bonds of banks expected to benefit from U.S. interest rate normalization.
* Thematic Strategies:
* Example: Buy the winning companies and short sell the losing companies (e.g., from Brexit).Managed futures
* Managed futures strategies are often employed during market stress and have demonstrated value during periods like the 2007-2009 financial crisis.
* Performance:
* Managers using this strategy may take short positions in equity futures and long positions in fixed-income futures.
* This strategy is effective when equity markets are falling and fixed-income indexes are rising, capitalizing on market shifts.
Specialist hedge fund strategies
Volatility Trading
* Volatility trading has become a distinct asset class in recent decades.
* Hedge fund managers specialize in trading relative volatility strategies across different geographies and asset classes.
* These strategies involve trading the fluctuations in market volatility, often using instruments like options and futures.Reinsurance/Life Settlements
* Hedge funds have increasingly ventured into the insurance and reinsurance sectors, including life settlements and catastrophe reinsurance.
* These contracts provide a payout to the policyholder (or beneficiary) upon the occurrence of a specific insured event (e.g., a life insurance payout when the policyholder passes away).
* Hedge funds invest in life settlements (purchasing life insurance policies at a discount) and catastrophe insurance.Example: Life Settlement Hedge Fund Strategy
* John Doe, aged 48, purchases a life insurance policy with the following terms:
* Annual premium: $25,000
* Face value (death benefit): $1,000,000
* After 20 years, at age 68, John suffers a disability, which significantly impacts his ability to work and manage his finances. Due to his inability to generate income and the high costs associated with medical treatment and nursing care, John decides to surrender the life insurance policy and receive the surrender value offered by the insurance company, which is $650,000.
* At this point, a hedge fund steps in and buys the policy from John for $650,000. The hedge fund will continue to pay the annual premiums of $25,000 and becomes the beneficiary of the policy, expecting to receive the $1,000,000 death benefit when John passes away.
* Questions:
* What would be the return for the hedge fund if John dies in 2 years?
* What would be the return for the hedge fund if John dies in 5 years?
Bank Sources of Funds
Deposit Accounts
Transaction Deposits: Checking accounts for writing checks.
Savings Deposits: Traditional savings accounts, no check writing.
Time Deposits: Withdrawable only at maturity.
Money Market Accounts: Limited check writing, higher yields, larger minimum balances.
Borrowed Funds
Federal Funds Purchased: Correct short-term imbalances.
Borrowing from Federal Reserve: For temporary fund shortages.
Repurchase Agreements.
Long-Term Funds
Bonds Issued: Finance fixed assets.
Bank Capital: Stock issuance and retained earnings.
Smaller banks more reliant on savings, larger banks on short-term borrowings.
Bank Uses of Funds
Cash Reserves: For Federal Reserve requirements.
Bank Loans.
Investment in Securities: Treasury securities, corporate bonds, mortgage-backed securities.
Federal Funds Sold, Repurchase Agreements, Fixed Assets.
Smaller banks have more household loans, larger banks more business loans.
Off-Balance Sheet Activities
Loan Commitments, Standby Letters of Credit, Forward Currency Contracts, Interest Rate Swaps, Credit Default Swaps.
Key Risks
Liquidity Risk: Inability to meet short-term obligations; mitigation via cash reserves.
Interest Rate Risk: Adverse changes impacting profitability; hedging to manage.
Credit Risk: Borrower defaults; mitigated with assessments and diversification.
Market Risk: Losses from market price changes; mitigated through strategies.
Managing Liquidity
Liability Management: Create liabilities or sell assets to resolve deficiencies.
Short-Term Investments: Balancing liquidity with returns.
Loan Management: Secondary markets improve liquidity.
Managing Interest Rate Risk
Net Interest Margin (NIM): Difference between interest income and expenses. NIM can drop when liabilities are more rate-sensitive.
Gap Analysis: Measure rate-sensitive assets vs. liabilities.
Duration Gap Analysis: Differences in asset and liability durations.
Reducing Interest Rate Risk
Maturity Matching: Align asset and deposit maturities.
Floating-Rate Loans: Support long-term with short-term deposits.
Interest Rate Futures/Swaps/Caps: Lock in prices or receive payments under certain conditions.
Introduction to Mutual Funds
Financial intermediaries pooling funds for investments. Provides diversification opportunities.
Pricing Mutual Funds
Net Asset Value (NAV): Price per share reflecting the fund’s value.
Open-End vs Close-End Funds
Open-End Funds: New investments accepted, can withdraw at NAV.
Closed-End Funds: Fixed shares traded in the market, can deviate from NAV.
Types of Mutual Funds
Money Market Funds: Invest in short-term instruments.
Bond Mutual Funds: Portfolio of bonds.
Stock Mutual Funds: Actively managed or indexed.
Hybrid Funds: Invest in both stocks and bonds.
Hedge Funds
Private investment vehicles employing diverse strategies for portfolio diversification.
Fee Structures: Management and performance fees are typical.
Bank Sources of Funds
Deposit Accounts
Transaction Deposits: Checking accounts for writing checks.
Savings Deposits: Traditional savings accounts, no check writing.
Time Deposits: Withdrawable only at maturity.
Money Market Accounts: Limited check writing, higher yields, larger minimum balances.
Borrowed Funds
Federal Funds Purchased: Correct short-term imbalances.
Borrowing from Federal Reserve: For temporary fund shortages.
Repurchase Agreements.
Long-Term Funds
Bonds Issued: Finance fixed assets.
Bank Capital: Stock issuance and retained earnings.
Smaller banks more reliant on savings, larger banks on short-term borrowings.
Bank Uses of Funds
Cash Reserves: For Federal Reserve requirements.
Bank Loans.
Investment in Securities: Treasury securities, corporate bonds, mortgage-backed securities.
Federal Funds Sold, Repurchase Agreements, Fixed Assets.
Smaller banks have more household loans, larger banks more business loans.
Off-Balance Sheet Activities
Loan Commitments, Standby Letters of Credit, Forward Currency Contracts, Interest Rate Swaps, Credit Default Swaps.
Key Risks
Liquidity Risk: Inability to meet short-term obligations; mitigation via cash reserves.
Interest Rate Risk: Adverse changes impacting profitability; hedging to manage.
Credit Risk: Borrower defaults; mitigated with assessments and diversification.
Market Risk: Losses from market price changes; mitigated through strategies.
Managing Liquidity
Liability Management: Create liabilities or sell assets to resolve deficiencies.
Short-Term Investments: Balancing liquidity with returns.
Loan Management: Secondary markets improve liquidity.
Managing Interest Rate Risk
Net Interest Margin (NIM): Difference between interest income and expenses. NIM can drop when liabilities are more rate-sensitive.
Gap Analysis: Measure rate-sensitive assets vs. liabilities.
Duration Gap Analysis: Differences in asset and liability durations.
Reducing Interest Rate Risk
Maturity Matching: Align asset and deposit maturities.
Floating-Rate Loans: Support long-term with short-term deposits.
Interest Rate Futures/Swaps/Caps: Lock in prices or receive payments under certain conditions.
Introduction to Mutual Funds
Financial intermediaries pooling funds for investments. Provides diversification opportunities.
Pricing Mutual Funds
Net Asset Value (NAV): Price per share reflecting the fund’s value.
Open-End vs Close-End Funds
Open-End Funds: New investments accepted, can withdraw at NAV.
Closed-End Funds: Fixed shares traded in the market, can deviate from NAV.
Types of Mutual Funds
Money Market Funds: Invest in short-term instruments.
Bond Mutual Funds: Portfolio of bonds.
Stock Mutual Funds: Actively managed or indexed.
Hybrid Funds: Invest in both stocks and bonds.
Hedge Funds
Private investment vehicles employing diverse strategies for portfolio diversification.
Fee Structures: Management and performance fees are typical.
Bank Sources of Funds
Deposit Accounts
Transaction Deposits: Checking accounts for writing checks.
Savings Deposits: Traditional savings accounts, no check writing.
Time Deposits: Withdrawable only at maturity.
Money Market Accounts: Limited check writing, higher yields, larger minimum balances.
Borrowed Funds
Federal Funds Purchased: Correct short-term imbalances.
Borrowing from Federal Reserve: For temporary fund shortages.
Repurchase Agreements.
Long-Term Funds
Bonds Issued: Finance fixed assets.
Bank Capital: Stock issuance and retained earnings.
Smaller banks more reliant on savings, larger banks on short-term borrowings.
Bank Uses of Funds
Cash Reserves: For Federal Reserve requirements.
Bank Loans.
Investment in Securities: Treasury securities, corporate bonds, mortgage-backed securities.
Federal Funds Sold, Repurchase Agreements, Fixed Assets.
Smaller banks have more household loans, larger banks more business loans.
Off-Balance Sheet Activities
Loan Commitments, Standby Letters of Credit, Forward Currency Contracts, Interest Rate Swaps, Credit Default Swaps.
Key Risks
Liquidity Risk: Inability to meet short-term obligations; mitigation via cash reserves.
Interest Rate Risk: Adverse changes impacting profitability; hedging to manage.
Credit Risk: Borrower defaults; mitigated with assessments and diversification.
Market Risk: Losses from market price changes; mitigated through strategies.
Managing Liquidity
Liability Management: Create liabilities or sell assets to resolve deficiencies.
Short-Term Investments: Balancing liquidity with returns.
Loan Management: Secondary markets improve liquidity.
Managing Interest Rate Risk
Net Interest Margin (NIM): Difference between interest income and expenses. NIM can drop when liabilities are more rate-sensitive.
Gap Analysis: Measure rate-sensitive assets vs. liabilities.
Duration Gap Analysis: Differences in asset and liability durations.
Reducing Interest Rate Risk
Maturity Matching: Align asset and deposit maturities.
Floating-Rate Loans: Support long-term with short-term deposits.
Interest Rate Futures/Swaps/Caps: Lock in prices or receive payments under certain conditions.
Introduction to Mutual Funds
Financial intermediaries pooling funds for investments. Provides diversification opportunities.
Pricing Mutual Funds
Net Asset Value (NAV): Price per share reflecting the fund’s value.
Open-End vs Close-End Funds
Open-End Funds: New investments accepted, can withdraw at NAV.
Closed-End Funds: Fixed shares traded in the market, can deviate from NAV.
Types of Mutual Funds
Money Market Funds: Invest in short-term instruments.
Bond Mutual Funds: Portfolio of bonds.
Stock Mutual Funds: Actively managed or indexed.
Hybrid Funds: Invest in both stocks and bonds.
Hedge Funds
Private investment vehicles employing diverse strategies for portfolio diversification.
Fee Structures: Management and performance fees are typical.