FRM Part II · FRM Exam Part II · The Investment Function in Financial Services Management
A bank has weak loan demand and a growing deposit base. The CFO proposes placing the surplus entirely in 30-year bonds to maximise yield. Which concern, relating to the objectives of the investment function, is most directly raised by this proposal?
The proposal places the earnings objective in conflict with liquidity and interest rate risk objectives. Thirty-year bonds have high price sensitivity to rate moves and can be sold only at potential losses, so the portfolio would not reliably serve as a liquidity buffer.
- AConflict between the earnings objective and the liquidity and interest rate risk objectivesCorrect
- BViolation of the requirement that investments must be tax-exempt
- CLoss of diversification because long-dated bonds are always correlated with loans of the same maturity
- DInability to use securities as collateral for borrowing
Explanation
Reaching for yield through very long maturities raises price sensitivity to rate changes and reduces liquidity, sacrificing the liquidity and risk-control objectives for earnings. Tax exemption is not a general requirement, and government bonds are usually acceptable collateral.
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