LOS j: Formulate an investment policy statement for a foundation, an endowment, an insurance company, and a bank.

Q1. Ranjana Clarkson, CFA, has just been hired by First National American (FNA), a small Midwestern U.S. bank. FNA is located in a town with a population of 50,000, adjacent to a large U.S Army installation. Other than the military base, the economy of the area is primarily agricultural. Beef cattle, wheat, and corn are the mainstay products.

Clarkson, originally from India, is married to a career military officer, hence she must relocate every few years. Despite her lack of banking experience, her supervisor was impressed with Clarkson’s investment expertise and prior work as an equity analyst and portfolio manager. He was anxious to hire someone with her credentials - a rarity in such a small community. Clarkson feels confident that she can make the transition to banking, but knows she needs to learn a lot more about the specifics of the industry, particularly with regard to how their securities portfolios are managed.

As part of her review process, Clarkson begins to assemble a notebook with pertinent information. Her progress so far is detailed below:

Figure 1: Objectives and Constraints

1. Earn a positive interest spread

2. Below average tolerance for risk

3. Contain liquid assets

4. Short to intermediate term time horizon

5. Highly regulated legal environment

6. Taxable

Figure 2: Management Approaches

Clarkson believes that the Federal Reserve will be raising interest rates regularly over next two years in an attempt to slow an overheating economy. She is considering how the bank could take advantage of that scenario, when her boss, Jason Anderman, stops by to see how she is coming along.

“I’ve been refreshing my memory about both the portfolio management process for banks and the accounting classifications mandated by FAS 115 for securities in a bank’s portfolio”, says Clarkson. “I seem to recall that unrealized gains and losses on available-for-sale (AFS) holdings show up in the balance sheet and the income statement. That’s why it’s so important to use highly liquid and shorter-duration securities.”

Anderman responds, “I thought that unrealized gains or losses were not reported either in the income statement or the balance sheet. Why don’t you chat with our Chief Financial Officer to verify that? We can discuss it again tomorrow at our morning staff meeting.”

The lowest priority use of a bank’s funds is for:

A)   reserve requirements.

B)   liquidity for depositor withdrawals.

C)   investing in securities.

Q2. Of the items shown in Figure One of Clarkson’s notebook which is the most important objective for a bank?

A)   Item 2.

B)   Item 3.

C)   Item 1.

Q3. With respect to the descriptions of the three portfolio management approaches detailed in Figure Two of Clarkson’s notebook:

A)   ladder is incorrect; barbell is correct; bullet is correct.

B)   ladder is incorrect; barbell is incorrect; bullet is incorrect.

C)   ladder is incorrect; barbell is incorrect; bullet is correct.

Q4. To make an aggressive bet on the interest rate environment that Clarkson anticipates, she should use a:

A)   barbell approach and under-weight investments in short-term securities.

B)   bullet strategy and over-weight investments in short-term securities.

C)   ladder approach and over-weight investments in short-term securities.

Q5. Regarding their statements about a bank’s securities that have been classified as available-for-sale:

A)   Clarkson is incorrect; Anderman is incorrect.

B)   Clarkson is correct; Anderman is incorrect.

C)   Clarkson is incorrect; Anderman is correct.

Q6. Which of the following statements about hold-to-maturity (HTM) securities held in a bank’s portfolio is FALSE? HTM securities:

A)   can become available for sale to meet unforeseen liquidity needs.

B)   do not report unrealized gains or losses on either the balance sheet or the income statement.

C)   can become available for sale if substantial credit deterioration occurs.

Q7. Which of the following is the most appropriate return objective for a private foundation that has been established to provide support in perpetuity?

A)   The long-term treasury bond return plus inflation.

B)   5.3% of assets plus expected inflation.

C)   The market return plus expected inflation.

Q8. The Carraway Endowment Fund was originally established to contribute to the support of the operations of Carraway Medical Center in the United States. The Carraway Fund currently has assets of $50 million, and the fund’s asset allocation at the end of 2001 is shown in the table below. In mid-2002, the Carraway Medical Center opened research facilities in Germany and Singapore. As a result of the expansion, the annual spending rate of the Carraway Fund was increased from 3.5% to 5.2% of total assets, and 30% of the fund’s annual payout was allocated to the new facilities. Support for the new operations must be provided in local currencies. Inflation is expected to be 3.0% during each of the next several years.

The most appropriate return objective for the Carraway Endowment Funds is closest to which of the following?

A)   8.2%.

B)   5.2%.

C)   8.7%.

Q9. Which of the following most appropriately addresses the Carraway Fund’s allocation to cash? Endowment funds:

A)   typically have low liquidity needs. Therefore, a 2.0% allocation to cash is excessive.

B)   typically have low liquidity needs. Therefore, a 2.0% allocation to cash should be sufficient to cover operating expenses.

C)   often have high liquidity needs. Therefore, a 10% allocation to cash may be necessary to cover operating expenses and unexpected liquidity needs.

Q10. Which of the following most appropriately addresses the Carraway Fund’s allocation to U.S. equities? The fund’s allocation to U.S. equities is:

A)   too high. A 50-55% allocation to U.S. equities is more appropriate.

B)   appropriate.

C)   too high. A 35-40% allocation to U.S. equities is more appropriate.

Thanks.