Chapter 10

The Investment Function in Banking and Financial-Services Management

Fill in the Blank Questions
1. A(n) _________________________ is a security issued by the federal government which has less
than one year to maturity when it is issued.
Answer: Treasury bill
2. Debt instruments issued by cities, states and other political entities and which are exempt from
federal taxes are collectively known as _________________________ .
Answer: municipal securities
3. The investment maturity strategy which calls for the bank to have one half of its investment
portfolio in very short term assets and one half of its investment portfolio in long term assets is
known as the _________________________ .
Answer: barbell strategy
4. A(n) _________________________ is a security where the interest portion of the security is sold
separately from the principal portion of the security.
Answer: stripped security
5. _________________________ are the way the federal, state and local governments guarantee the
safety of their deposits with banks.
Answer: Pledging requirements
6. The most aggressive investment maturity strategy calls for the bank to continually shift the
maturities of its securities in responses to changes in interest rates and is called the
__________________.
Answer: rate expectation strategy
7. _________________________ is the risk that the bank will have to sell part of its investment
portfolio before their maturity for a capital loss.
Answer: Liquidity risk
8. _________________________ is the risk that the economy of the market area they service may
take a down turn in the future.
Answer: Business risk

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9.
__________________ is the risk that the company whose bonds the financial institution
owns may retire the entire issue of corporate bonds in advance of their maturity leaving the bank with the
risk of earnings losses resulting from reinvesting the cash at lower interest rates.
Answer: Call risk
10. A security issued by the federal government with 1 to 10 years to maturity when it is issued is
called a(n) _________________________ .
Answer: Treasury note
11. A short term debt security issued by major corporations is known as __________________.
Answer: commercial paper
12. The investment maturity strategy which calls for the bank to have all of their investment assets in
very short term maturities is called the _________________________.
Answer: front-end-loaded policy
13. A money market security which represents a bank's commitment to pay a stipulated amount of
money on a specific future date under specific conditions and which is often used in international
trade is known as a(n) _________________________.
Answer: bankers' acceptance
14. A(n) _________________________ is an interest-bearing receipt for the deposit of funds in a
bank for a stipulated time period. Ones that are oriented towards business customers or
institutions are known as jumbos.
Answer: certificate of deposit
15. _________________________ are any securities which reach maturity in under one year.
Answer: Money market securities
16. _________________________ are any securities whose original maturity exceeds one year.
Answer: Capital market securities
17. Securities sold by Fannie Mae, Freddie Mac and others are known as
_________________________.
Answer: federal agency securities
18. Claims against the expected income and principal generated by a pool of similar-type loans are
known as _________________________.
Answer: securitized assets

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19.
The long term debt obligations of major corporations are known as
________________________.
Answer: corporate bonds
20. The investment maturity strategy which calls for the bank to have all of their investment assets in
very long term maturities is known as the _________________________.
Answer: back-end-loaded policy
21. Financial Institutions may invest in municipal bonds issued by smaller local governments. These
bonds are known as ____________ bonds.
Answer: bank qualified

22. Marketable notes and bonds sold by agencies owned by the government or sponsored by the
government are known as
Answer: government agency securities

23. A security issued by the federal government with greater than 10 years to maturity when it is
issued is called a(n)
Answer: Treasury Bond

24.

are time deposits of fixed maturity issued by the worlds larges

banks headquartered in financial centers around the globe. The heart of this market is centered in
London.
Answer: Eurocurrency deposits

25.

are a type of municipal bond that are backed by the full faith and
credit of the issuing government.
Answer: General obligation bonds

26.

are a type of municipal bond that are paid only from certain
stipulated source of funds.
Answer: Revenue bonds

27.

are closely related to CMOs and partition the cash flow from a pool
of mortgage loans or mortgage backed securities into multiple maturity classes in order to reduce
the cash-flow uncertainty of investors.
Answer: Real Estate Mortgage Investment Conduits (REMICs)

28.

is the risk that loans will be terminated or paid off ahead of schedule.
This is a particular problem with residential home mortgages and other consumer loans that are
pooled and used as collateral in securitized assets.

Test Bank, Chapter 10

Answer: Prepayment risk

29. A lending institution that sells lower-yielding securities at a loss in order to reduce current taxable
income while simultaneously purchasing higher-yielding new securities in order to boost future
returns is doing a(n)
.
Answer: tax swap

30. A(n)

is a picture of how market interest rates differ across loans

securities of varying times to maturity.
Answer: yield curve

True/False Questions
T

F 31. Investments in securities provide diversification for a bank's assets because most loans
come from the local areas served by a bank's offices.
Answer: True

F 32. Bank income from loans is fully taxable.

Answer: True

F 33. Investment securities are expected to "dress up" a bank's balance sheet, according to the
textbook.
Answer: True

F 34. Investment securities are expected to help stabilize a financial institutions's income.
Answer: True

F 35. A short-term IOU offered by major corporations that is of short maturity (most of these
lOUs mature in 90 days or less) is known as a CMO.
Answer: False

F 36. Prepayment risk on securitized assets generally increases when interest rates rise.
Answer: False

F 37. Stripping a security eliminates prepayment risk.

Answer: False

F 38. According to the textbook the dominant security held in U.S. bank investment portfolios
is state and local government bonds.
Answer: False

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F 39. Interest income and capital gains from a bank's portfolio of investment securities is taxed
in the United States as ordinary income.
Answer: True

F 40. Eurocurrency deposits that some banks purchase as investments generally carry higher
market yields than domestic time deposits issued by comparable-size U.S. banks.
Answer: True

F 41. Bankers' acceptances are considered to be among the safest of all money market
instruments.
Answer: True

F 42. An eligible acceptance is one that can be used as collateral for borrowing from a Federal
Reserve bank.
Answer: True

F 43. When a bank irrevocably guarantees a commercial paper issue, the bank's credit rating
substitutes for the borrower's credit rating.
Answer: True

F 44. The principal risk banks face from investing in structured notes is credit (default) risk.
Answer: False

F 45. The principal risk to a financial institution buying CMOs is market risk.
Answer: False

F 46. Stripped mortgage-backed securities fully protect investors from having to reinvest their
income at lower and lower interest rates.
Answer: False

F 47. Stripped mortgage-backed securities make maturity matching of bank assets and
liabilities easier to accomplish than do most other investment securities that banks buy.
Answer: False

F 48. Lower interest rates increase the present value of all projected cash flows from a loanbacked security so that its market value could rise.
Answer: True

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F 49. Treasury bills are the long term debt obligations issued by the federal government.
Answer: False

F 50. Commercial paper is the short term debt instrument issued by major banks.
Answer: False

F 51. Treasury notes and bonds are issued by the federal government and are coupon
instruments.
Answer: True

F 52. Interest rate risk is the risk financial institutions face due to changes in market interest
rates.
Answer: True

F 53. One investment maturity strategy popular among smaller institutions is the ladder or
spaced maturity policy. It is popular because it does not take much expertise to
implement.
Answer: True

F 54. One investment maturity strategy, called the front end loaded policy, requires that the
bank put all of its investment portfolio in long term securities.
Answer: False

F 55. Business risk is the risk that the bank will experience a cash shortage and will have to sell
some of its investments securities.
Answer: False

F 56. Inflation risk is the possibility that the purchasing power of interest income and repaid
principal from a security or loan will be eroded by rising prices for goods and services.
Answer: True

F 57. Call risk refers to the right of debt collectors to call in the loans in advance of maturity
and get an early repayment.
Answer: False

F 58. If interest rates fall, a callable bond at par has the potential for large increases in price.
Answer: False

F 59. The yield to maturity is the discount rate that equates a securitys purchase price with the
stream of income expected until it is sold to another investor.

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Answer: False
Multiple Choice Questions

60.

An important investment security popular with banks that must by law mature within one year
from the date of issue and which has a high degree of safety and marketability is the:
A) Treasury bill
B) Treasury note
C) FNMA note
D) Bankers' acceptance
E) Eurodollar CD
Answer: A

61.A bank's promise to pay the holder a designated amount of money on a designated future date and is
often used in international trade is known as a (or an):
A) Promissory guarantee
B) Discount security
C) Bankers' acceptance
D) In the money option
E) Accretion note
Answer: C

62. Pools of mortgages put together either by a government agency or by a private investment
banking corporation to raise more loanable funds for the issuer are known as a (or an):
A) Accretion bond
B) Participation certificate
C) CMO
D) Stripped security
E) Commercial paper
Answer: C

63. Fluctuations in the timing of cash payments flowing from an underlying pool of securitized assets
is referred to as:
A) Income risk
B) Prepayment risk
C) Liquidity risk
D) Capital risk
E) None of the above
Answer: B

64. Principal roles that a financial institution's investment portfolio play include which of the
following?
A) Income stability
B) Geographic diversification

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C) Hedging interest rate risk

D) Backup liquidity
E) All of the above
Answer: E

65. _____________ is the method by which banks can provide a safeguard for the deposits of
governmental units.
A) Hedging
B) Collateralization
C) Pledging
D) Securitization
E) Window dressing
Answer: C

66. The most aggressive investment maturity strategy that calls for the bank to continually shift the
maturities of its securities in response to changes in interest rates and other economic conditions
is the
A) Barbell strategy
B) Rate expectations approach
C) Front-end-loaded policy
D) Ladder approach
E) None of the above
Answer: B

67.Which of the following statements is (are) correct regarding duration?

A) In comparing two bonds with the same yield to maturity and the same maturity, a bond with a
higher coupon rate will have a longer duration.
B) In comparing two loans with the same maturity and the same interest rate, a fully amortized
loan will have a shorter duration than a loan with a balloon payment.
C) The duration will always be shorter than the maturity for all debt instruments.
D) All of the above
E) B and C
Answer: B

68.Which of the following is not one of the Capital Market instruments in which banks invest?
A) U.S. Treasury notes
B) Corporate notes and bonds
C) U.S. Treasury bonds
D) Municipal bonds
E) Commercial paper
Answer: E

69.

Which of the following is true of Treasury bills?

A) Interest on Treasury bills is exempt from state income taxes.

B) Interest on Treasury bills is exempt from federal income taxes.
C) Treasury bills pay a lower pretax yield than comparable corporate securities.
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D) All of the above are true.

E) A and C only
Answer: E

70. In recent years security dealers have assembled pools of federal agency securities whose principal
interest yield may be periodically reset based on what happens to a stated interest rate or may
carry multiple coupon rates that are periodically adjusted; the foregoing describes a:
A) Financial futures contract
B) Revenue-anticipation note
C) Zero coupon instrument
D) Structured note
E) None of the above
Answer: D

71.

Banks are generally not allowed to invest in speculative grade bonds. What kind of risk is this
designed to limit?
A) Liquidity risk
B) Business risk
C) Credit risk
D) Tax exposure
E) Interest rate risk
Answer: C

72.A security where the interest payments and the principal payments are sold separately is called:
A) A Treasury note
B) An accretion
C) A structured note
D) A stripped security
E) None of the above
Answer: D

73.Which of the following is true? Mortgage prepayment risk:

A) Is higher on high interest rate mortgages
B) Is felt most dramatically when interest rates rise
C) Is eliminated by the use of mortgage backed securities
D) Is eliminated by the purchase of a stripped mortgage obligation
E) All of the above are true
Answer: A

74. A bank replaces 5-year corporate bonds with a yield to maturity of 9.75 percent with 5-year
municipal bonds with a yield to maturity of 7 percent. This bank is in the 35 percent tax bracket
and these bonds have the same default risk. What is the most likely reason this bank changed from
the corporate to the municipal bonds?
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Test Bank, Chapter 10

A) Liquidity risk
B) Business risk
C) Credit risk
D) Tax exposure
E) Interest rate risk
Answer: D

75. Suppose a bank has found bank qualified municipal bonds which have a nominal gross rate of
return of 8 percent and that it can borrow funds needed for this purchase at a rate of 6.25 percent.
This bond is in the 35 percent tax bracket. What is the net after-tax return on this bond?
A) 5.20 percent
B) 3.5 percent
C) 1.75 percent
D) 0 percent
E) None of the above
Answer: B

76. An investor can invest in either a tax-exempt security that pays 5% or a taxable corporate security
of comparable risk and maturity that pays 8%. At what marginal tax rate will the investor be
indifferent between these two securities?
A) 25.0%
B) 32.5%
C) 37.5%
D) 57.5%
E) 62.5%
Answer: C

77.

Which of the following would not be considered a bank qualified municipal security?
A) A Columbia County general obligation bond to modernize the county fire department.
B) A Bucks County general obligation bond to build a new sewer plant.
C) A City of San Marcos general obligation bond to pay for street repairs.
D) A City of Chicopee general obligation bond to pay for a new city jail.
E) A Treasury bond to finance government debt.
Answer: E

78. A bond has three years to maturity and has a coupon rate of 15 percent. This bond is selling in
the market for $1072 and has a yield to maturity of 12%. What is the duration of this bond?
A) 3 years
B) 1 year
C) 1.92 years
D) 2.45 years
E) 2.64 years
Answer: E

79. A bond has six years to maturity and has a coupon rate of 7.5 percent. Coupon payments are
made annually and this bond has a face value of $1000. This bond is selling in the market for
$1127. What is the yield to maturity on this bond?

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11

A) 7.5 percent
B) 5 percent
C) 11.5 percent
D) 2.5 percent
E) None of the above
Answer: B

80. A bond has eight years to maturity and a coupon rate of 6.5 percent. Coupon payments are made
annually and this bond has a face value of $1000. This bond is selling in the market for $862.
What is the yield to maturity on this bond?
A) 6.5 percent
B) 10 percent
C) 8.5 percent
D) 9 percent
E) None of the above
Answer: D

81. A bond has eight years to maturity and a coupon rate of 6.5 percent. Coupon payments are made
annually and this bond has a face value of $1000. This bond is selling in the market for $862. If
this bond is sold at the end of four years for $1046, what is the holding period return on this
bond?
A) 6.5 percent
B) 12 percent
C) 9 percent
D) 6 percent
E) None of the above
Answer: B

82.A security which was created by the Treasury to protect against inflation risk is called a(n):
A) CMO
B) FNMA
C) GNMA
D) TIPS
E) CD
Answer: D

83. A financial institution that is concerned about the possibility that the purchasing power of both
the interest income and principal income will decline on a loan is concerned about which of the
following things?
A) Business risk
B) Liquidity risk
C) Tax exposure
D) Credit risk
E) Inflation risk
Answer: E

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Test Bank, Chapter 10

84. A bank that is concerned that the economic conditions of the market area they serve may take a
downturn with falling demand for loans and higher bankruptcies in the areas is concerned about
which of the following things?
A) Business risk
B) Liquidity risk
C) Tax exposure
D) Credit risk
E) Inflation risk
Answer: A

85.Which of the following is a characteristic of Treasury bills?

A) They are coupon instruments
B) They are the short term debt instruments issued by major corporations
C) They are discount securities
D) They have more risk than other money market securities
E) All of the above are characteristics of Treasury bills
Answer: C

86. The investment maturity strategy which calls for the bank to put all of their investment assets into
very long term securities is called the:
A) Front-end-loaded maturity policy
B) Back-end-loaded maturity policy
C) Ladder or spaced maturity policy
D) Barbell investment portfolio strategy
E) Rate expectation approach
Answer: B

87.

The Lancaster State Bank is thinking about purchasing a corporate bond

that has a yield of 8.5%. This bank has a marginal tax rate of 25%. What is
the after-tax yield on this bond?
A) 11.33%
B) 8.5%
C) 6.375%
D) 2.125%
E) None of the above
Answer: C

88. The Ferson National Bank is thinking about purchasing a municipal bond that
has a yield of 5.5%. This bank has a marginal tax rate of 30%. What is the
after-tax yield on this bond?
A) 7.86%
B) 5.5%
C) 3.85%
D) 1.65%
E) None of the above

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Answer: B

89. The Stumbaugh State Bank is thinking about purchasing a corporate bond

that has a yield of 9%. This bank has a marginal tax rate of 40%. What is the
after-tax yield on this bond?
A) 15%
B) 9%
C) 5.4%
D) 3.6%
E) None of the above

90. The Price Perpetual Bank has purchased a bond that has a coupon rate of

5.5% and a face value of $1000. It has 11 years to maturity and is selling in
the market for $887.52. The bond makes annual coupon payments. What is
the yield to maturity on this bond?
A) 7%
B) 5.5%
C) 11%
D) 4.70%
E) None of the above
Answer: A

91. The Price Perpetual Bank has purchased a bond that has a coupon rate of
5.5% and a face value of $1000. It has 11 years to maturity and is selling in
the market for $887.52. The bond makes annual coupon payments. The
Price Perpetual Bank is planning on selling this bond at the end of 5 years for
$1036.50. What is the holding period return on this bond?
A) 5.5%
B) 7%
C) 11%
D) 9%
E) None of the above
Answer: D

92. The Farmer National Bank has purchased a bond that has a coupon rate of
11.5% and a face value of $1000. It has 16 years to maturity and is selling in
the market for $1309.80. The bond makes annual coupon payments. What is
the yield to maturity on this bond?
A) 11.5%
B) 16%
C) 8%
D) 12.21%
E) None of the above
Answer: C

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Test Bank, Chapter 10

93. The Farmer National Bank has purchased a bond that has a coupon rate of

11.5% and a face value of $1000. It has 16 years to maturity and is selling in
the market for $1309.80. The bond makes annual coupon payments. The
Farmer National Bank plans on selling this bond at the end of 8 years for
$1071. What is the holding period return on this bond?
A) 7%
B) 8%
C) 11.5%
D) 16%
E) None of the above
Answer: A

94. The Johnson National Bank has purchased a bond that has a coupon rate of

5.5% and a face value of $1000. It has 4 years to maturity and is selling in
the market for $917. The bond makes annual coupon payments. What is the
yield to maturity on this bond?
A) 5.5%
B) 4.0%
C) 1.5%
D) 8%
E) None of the above

95. The Johnson National Bank has purchased a bond that has a coupon rate of
5.5% and a face value of $1000. It has 4 years to maturity and is selling in
the market for $917. The bond makes annual coupon payments. What is the
duration of this bond?
A) 3.38 years
B) 3.68 years
C) 4.00 years
D) 5.50 years
E) None of the above
Answer: B

96. The Sheets Savings and Loan Association has purchased a bond that has a
coupon rate of 7.5% and a face value of $1000. It has 5 years to maturity
and is selling in the market for $1063. The bond makes annual coupon
payments. What is the duration of this bond?
A) 7.50 years
B) 5.00 years
C) 4.65 years
D) 4.37 years
E) None of the above
Answer: D

97. The Dillinger State Bank has purchased a bond from the Interstate
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Manufacturing Company that has 15 years to maturity and has a coupon rate
of 12.5%. Market interest rates have recently declined to 8% and the
Dillinger State Bank is worried that the Interstate Manufacturing Company
will retire the bond and issue new ones with a lower coupon rate. What type
of risk is the Dillinger State Bank worried about?
A) Credit risk
B) Interest-rate risk
C) Business- risk
D) Call risk
E) Prepayment risk
Answer: E

98. The Terrell State Bank is a small bank located in Guyman, Oklahoma. All of

their loans are agriculture and small business loans in Guyman. They want to
buy a municipal bond from the state of South Carolina. What type of risk are
they likely trying to reduce with this purchase?
A) Credit risk
B) Interest-rate risk
C) Business risk
D) Call risk
E) Prepayment risk
Answer: C

99.

The Caldwell National Bank has purchased a bond that pays a coupon rate of
10.5%. They are a little concerned because they believe rates will decrease
in the future and they will not be able to reinvest the coupon payments at the
same rate. What type of risk are they concerned about?
A) Credit risk
B) Interest rate risk
C) Business risk
D) Call risk
E) Prepayment risk
Answer: B

100. Moodys Investor Service has added the numbers 1, 2 and 3 to some of their
ratings. What type of risk are these ratings attempting to measure?
A) Credit risk
B) Interest rate risk
C) Business risk
D) Call risk
E) Prepayment risk
Answer: A

101. The Roy State Bank has just purchase a portfolio of asset backed securities.
What type of risk do these securities have that other securities do not have?

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Test Bank, Chapter 10

A) Credit risk
B) Interest rate risk
C) Business risk
D) Call risk
E) Prepayment risk
Answer: E

102. The Carey State Bank has purchased a bank-qualified municipal bond with a

yield of 6%. This bank has had to borrow funds to make this purchase at a
cost of 5.25%. This bank is in the 40% tax bracket. What is the net after-tax
return on this bank-qualified municipal bond?
A) 6.00%
B) .75%
C) 2.85%
D) 2.43%
E) None of the above
Answer: D

103. The Wesson Wisconsin State Bank has purchased a bank-qualified municipal
bond with a yield of 7.5%. This bank had to borrow funds to make this
purchase at a cost of 6%. This bank is in the 25% tax bracket. What is the
net after-tax return on this bank-qualified municipal bond?
A) 7.5%
B) 2.7%
C) 3.0%
D) 1.5%
E) None of the above
Answer: B

104. The Goodknight Company has issued securities with 45 days to maturity.
What type of security have they issued?
A) Commercial Paper
B) Bankers Acceptance
C) Corporate Bond
D) Certificate of Deposit
E) Municipal Bond
Answer: A

105. The Dakota National Bank has purchased a security issued by the state of
Tennessee that has 20 years to maturity. What type of security have they
purchased?
A) Commercial Paper
B) Bankers Acceptance
C) Corporate Bond
D) Certificate of Deposit
E) Municipal Bond

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Answer: E

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