06-20-07 FPAC Minutes - Laserfiche WebLink

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• GD Government Finance Officers Association Recommended Practice Managing Market Risk in a Portfolio(2007) (CASH) (formerly known as Maturities of Investments in a Portfolio- 1997 and 2002) Background.Fixed-income securities are investment instruments that provide a stream of cash flows in the form of coupon and principal payments. Typically, they are issued with maturities ranging from overnight to 30 years. A security's stated maturity is the date on which its final interest and principal payments are due. There are several general structures for fixed-income securities: • Bullet securities—the principal payment will be paid in one payment at maturity. They are - issued without any option that could cause redemption prior to the stated maturity; • Securities with options—issued with 1 of 2 options that could change the stream of cash flows. Call options give the issuer the right to redeem bonds prior to maturity in accordance with the call schedule. Put options give the investor the right to submit a bond for redemption prior to maturity in accordance with the rules of the put; and • Amortizing securities—pay a portion of the principal with each interest payment throughout • the life of the bond (e.g.—mortgage securities, asset-backed securities). They have a stated final maturity and an average maturity, and can also have early redemption options. Market risk refers to the effect that changing interest rates have on the value of a fixed-income security. There is an inverse relationship between interest rates and price. As interest rates rise,the value of a security falls. The reverse is true as interest rates fall. The extent of price change is a function of the length of term to maturity, the level of interest rates and the size of the coupon. Of these factors,the most important is the length of term to maturity. Generally, the longer the maturity of a security,the greater its market risk as measured by price volatility. Longer maturities have greater volatility because as the time to maturity increases, each change in interest rates has a greater impact on the present value of a security. The size of a security's coupon will also impact price volatility. When analyzing securities with the same maturity, securities with low coupons will have greater price volatility than securities with high coupons. The security with the greatest price volatility for any given maturity is a zero coupon security. Market risk is generally the greatest risk that a government investor manages. Therefore,it is important to understand fully the maturity structure of securities before investing. To ensure appropriate liquidity and to reduce interest rate risk in operating portfolios, most state and local governments: 1. Limit the maximum maturity for securities they purchase; 2. Ensure that funds are available for scheduled disbursement by developing cash flow projections and properly structuring the maturities in a portfolio according to the expected cash flows; and 3. Ensure that a security can be sold with ease and minimal cost(price disruption)to the investor by investing in high grade, actively traded fixed-income securities.