Chapter -9

Investment Portfolio and

Liquidity Management
 Concept of portfolio
•Investment portfolio is a collection of investment instruments like
shares, mutual funds, bonds, fixed deposits and other cash
equivalents etc.
•Portfolio management is the art of selecting the right investment
tools in the right proportion to generate optimum returns from the
investment made.
•Portfolios are held directly by investors and/or managed by
financial professionals.
•Best portfolio management practice runs on the principle of
minimum risk and maximum return within a given time frame. A
portfolio is built based on investor’s income, investment budget
and risk appetite keeping the expected rate of return in mind.
 Importance of Investment Portfolio

When an investment portfolio is built, following objectives

are to be kept in mind by the portfolio manager based on
an individual’s expectation. The choice of one or more of
these depends on the investor’s personal preference. The
objectives of the investment portfolio are as follows:
i. Income
ii.Appreciation
iii.Safety and Liquidity
iv.Hedge against inflation
v. Method of Tax Planning
Importance of Portfolio
•Portfolio management presents the best investment plan to the individuals as per their
income, budget, age and ability to undertake risks. Portfolio management minimizes the
risks involved in investing and also increases the chance of making profits. Portfolio
managers understand the client’s financial needs and suggest the best and unique
investment policy for them with minimum risks involved. Portfolio management
enables the portfolio managers to provide customized investment solutions to clients as
per their needs and requirements.
•The benefits of having an investment portfolio can be far-reaching, possibly lasting for
generations to come. Wise investing can help an individual not only to guard his initial
investment but also grow that capital to levels that it would not otherwise have attained.
With investments come certain privileges, not the least of which is to enjoy the profits
that the company earns and shares with investors. While an investment portfolio
introduces some risk, it also offers an investor some control over his financial future.
i. Diversification
ii.Potential
iii.Income
iv.Liquidity
Money Market Instrument
Investments in the money market are debt instruments with maturities
of under a year, usually 90 days or less. Because the minimum
investment required to purchases money market instruments is
generally very large, the market is dominated by commercial banks,
state and local governments, financial and non-bank institutions. These
large investors purchase money market instruments to convert
temporary cash surpluses into highly liquid interest bearing
investments. The principal money market instruments are treasury
bills, negotiable certificates of deposit, Eurodollar deposits,
commercial paper, bankers’ acceptances, and repurchase agreements.
1.Treasury bills
2.Open market operation
3.Interbank Transaction
4.Commercial paper
Capital Market Instrument
Money market securities are purchased primarily to earn interest on
temporary cash balances. These investments are of short duration and
offer a high degree of safety for their principal amount, because the
issuers generally have the highest credit ratings. Fixed income securities,
however, include debt instruments with longer maturities. In the capital
market, therefore, investor can commit funds for longer periods of time
and purchase securities with a greater degree of risk in expectation of
higher returns. Fixed income securities include various kinds of bonds.
These securities will be further analyzed in later chapters.
1.Corporate stock or share
2.Preferred stock
3.Debenture
4.Government bonds
 Liquidity Management
•A bank is considered to be liquid if it has ready access to immediately
spendable funds at reasonable cost at exactly the time those funds are
needed. Thus, the liquid bank either has the right amount of immediately
spendable funds on hand when they can quickly raise liquid funds by
borrowing or by selling assets.
•Short of adequate liquidity is the serious financial trouble. The troubled
bank usually begins to lose deposits, which erodes its supply of cash and
forces the institution to dispose of its more liquid assets. Other banks also
deny lending the troubled bank any funds without additional collateral or a
high interest rate and this result the earnings of the institution and threaten
the failure.
• Most of the bank assumes that liquid funds can be borrowed without limit
any time they are needed. Thus, they need to store liquidity in the form of
easily marketed, stable price assets. The huge cash shortages experienced
in recent years by banks in trouble make clear that liquidity
 Estimation of Liquidity
Banks and other financial institutions attempt to forecast their
liquidity needs using several approaches. Though liquidity
needs may not be accurately estimated, it provides banks
opportunity to be able to meet the needs. Liquidity estimate
enables banks to have liquidity reserves made up of planned and
protective components.
Liquidity needs estimation techniques include:
i. The sources and uses of funds approach;
ii. The structure of funds approach;
iii. The liquidity indicator approach, and
iv. The market signals (or discipline) approach.
The Sources and uses of fund approach
Bank liquidity rises as deposits increase and loans decrease. Bank liquidity declines when
deposits decease and loans increases. This approach is based on existence of liquidity gap
between sources and uses of funds. If the sources and uses do not match, the bank has a
liquidity gap measured by the size of the total difference between its sources and uses of
funds. When sources of liquidity exceed uses of liquidity, the bank will have a positive
liquidity gap. Its surplus funds must be invested in earnings assets until they are needed to
cover the future needs. On the other hand, when uses of liquidity exceed sources of
liquidity, the bank faces a liquidity deficit, or negative liquidity gap. The bank must raise
funds from the cheapest and most timely sources available.
There are three steps involved in the uses of the sources and uses of funds approach.
• Forecast the loans and deposits for a given liquidity planning period
• Calculate the estimated change in loans and deposits for the same period.
• Estimate the net liquidity funds’ surplus or deficit for the planning period by comparing
the estimated change in loans (or other uses of funds) to the estimated change in deposits
(or other sources of funds)
The forecast loans and deposits above are used to estimate the liquidity needs of banks.

Estimated liquidity deficit (–) or surplus (+) for the coming period
= Estimated change in total deposits – Estimated change in total loans
 Structure of Deposit Method
The structure of funds approach is a method for estimating a bank’s liquidity needs
by dividing its borrowed funds into categories based on their probability of
withdrawal and therefore lost to the bank. The bank’s deposit and non-deposit
liabilities divided into three categories.
First divides deposits and other funds sources into different categories depending
on the probability of withdrawals. These categories are usually as follows:
a. “Hot money” liabilities (volatile liabilities): Hot money liabilities are that
deposits and other borrowed funds that are very interest sensitive deposits and
borrowed funds that expected to be withdrawn in current period.
b. Vulnerable funds: Vulnerable funds are that deposits of substantial portion,
perhaps 25 or 30 percent is likely to be withdrawn in current period.
c. Stable funds (core deposits/liabilities): Funds that management considers
most unlikely to be withdrawn.
•Second, the liquidity manager must allocate the liquid funds for each category
of funds according to some operating rules. For example, the manager may
decide to set up a 95 percent liquid reserve behind all hot money funds (less any
reserves the bank holds behind not money deposits). This liquidity reserve might
consist of holdings of immediately spendable deposits in correspondent banks
plus investments in treasury bills and repurchase agreements where the
committed funds can be recovered in a matter of minutes or hours.
•A common rule of thumb for vulnerable deposit and non-deposit liabilities is to
hold a fixed percentage of 30 percent of their total amount in liquid reserves. For
stable (core) funds sources, the bank may decide to place a small proportion of
15 percent or less of their total in liquid reserves. Thus, the liquidity reserve
behind the bank deposit and non-deposit liabilities would be as follows:
• Liability liquidity reserve = 0.95 × (Hot money funds – Legal reserve held)
+ 0.30 × (Vulnerable funds – Legal reserves held) + 0.15 × (Stable funds –
Legal reserves held)
•Total liquidity requirement = 0.95 × (Hot money funds – Legal reserve held) + 0.30 ×
(Vulnerable funds – Legal reserves held) + 0.15 × (Stable funds – Legal reserves held) +
1.00 (Potential loans outstanding – Actual loans outstanding)
 Liquidity indicators Approach
This approach estimate liquidity needs by relying on the use of experience and industry
averages. This approach uses different liquidity indicators ratios such as:
a. Cash position indicator: Cash and deposits due from depository institutions ÷ total assets,
where a greater proportion of cash implies the bank is in a better position to handle
immediate cash needs.
b. Liquid security indicator: Government securities ÷ total assets, which compares the most
marketable securities a bank can hold with the overall size of its asset portfolio; the greater
the proportion of government securities, the more liquid the bank’s position.
c. Net federal funds position: (federal funds sold – federal funds purchased and repurchase
agreements) ÷ total assets, which measures the comparative importance of overnight loans to
overnight borrowings of reserves. The higher the ratio, the liquidity tends to increase.
d. Capacity ratio: Net loans and leases ÷ total assets, which is really a negative liquidity
indicator because loans and leases are often among the most illiquid assets a bank can hold.
e. Pledge security ratio: Pledge securities ÷ total security holds, also a negative liquidity
indicator because the greater the proportion of securities pledged to back government
deposits, the fewer securities are available to sell when liquidity needs arise.
f. Hot money ratio: Money market assets ÷ money market liabilities = (cash + short
term government securities + federal funds loans + reverse repurchase agreements) ÷
(large CDs + Eurocurrency deposits + federal funds borrowed + repurchase
agreements). This ratio reflects whether the bank has balanced its borrowings in the
money market with increases in its money market assets that could be sold quickly to
cover those money market liabilities.
g. Deposit brokerage index: Brokered deposits ÷ total deposits, where brokered
deposits consist of packages of funds (usually $ 100,000 or less to gain the advantage
of deposit insurance) placed by securities brokers for their customers with banks
paying the highest yields. Brokered deposits are highly interest sensitive and may be
quickly withdrawn; the more the bank holds, the greater the chance of a liquidity crisis.
h.Core deposit ratio: Core deposit ÷ total assets, where core deposits are defined as
total deposits less all deposits over $ 100,000. Core deposits are primarily small
denomination accounts from local customers that are considered unlikely to be
withdrawn on short notice and so carry lower liquidity requirements.
i. Deposit composition ratio: Demand deposits ÷ time deposits, where demand deposits
are subject to immediate withdrawal via check writing, while time deposits have fixed
maturities with penalties for early withdrawal. This ratio measures how stable a
funding base each bank possesses; a decline in the ratio suggests greater deposit
stability and, therefore, a lessened need for liquidity.
Market signal Approach
•This is a qualitative approach to measuring liquidity
requirement of banks. It is technique that centres on the
discipline of the financial market place, which subject banks
to series of market’s tests, such as the ability of bank to pass
the following tests:
a. Public confidence
b. Stock price behaviour
c. Risk premium on CDs and other borrowings
d. Loss sales of assets
e. Meeting commitments to credit customers
f. Borrowings from the central bank.
 List of formula
1. Net liquidity position = Total Cash Inflows – Total Cash Outflows
2. Total liquidity requirement = 0.95 × (Hot money funds – Legal reserve held) +
0.30 × (Vulnerable funds – Legal reserves held) + 0.15 × (Stable funds – Legal reserves
held) + 1.00 (Potential loans outstanding – Actual loans outstanding)
3. Net liquidity surplus = liquidity supplies – Liquidity Demands – Deposit
Withdrawals
4. Liquidity indicators includes
i. Cash position indicators = (Cash and deposit due from other banks)/(Total
assets)×100
ii. Net Federal Funds position = ((Federal Funds Sold-Federal Funds
Purchase))/(Total assets)×100
iii. Capacity Ratio = ( Net Loans and lease)/(Total assets)×100
iv. Deposit Composition Ratio = (Demand Deposit)/(Time Deposit)×100
v. Liquidity Securities Indicator =(U.S Government Securities)/(Total assets)×100
Vi. Reserve Credit = Average Clearing balance × Annualized Fed. funds Rate × (Reserve
maintence period)/(Days in year i.e 360)×100