A System For Bank Portfolio Planning 14 - MIT

A System for Bank Portfolio Planning 14 Commercial banks and, to a lesser degree, other financial institutions have substantial holdings of various types of federal, state, and local government bonds. At the beginning of 1974, approximately twenty-five percent of the assets of commercial banks were held in these types of securities. Banks hold bonds for a variety of reasons. Basically, bonds provide banks with a liquidity buffer against fluctuations in demand for funds in the rest of the bank, generate needed taxable income, satisfy certain legal requirements tied to specific types of deposits, and make up a substantial part of the bank’s investments that are low-risk in the eyes of the bank examiners. In this chapter, we present a stochastic

programming model to aid the investment-portfolio manager in his planning. The model does not focus on the day-to-day operational decisions of bond trading but rather on the strategic and tactical questions underlying a successful management policy over time. In the hierarchical framework presented in Chapter 5, the model is generally used for tactical planning, with certain of its constraints specified outside the model by general bank policy; the output of the model then provides guidelines for the operational aspects of daily bond trading. The model presented here is a large-scale linear program under uncertainty. The solution procedure employs the decomposition approach presented in Chapter 12, while the solution of the resulting subproblems can be carried out by dynamicprogramming, as developed in Chapter 11. The presentation does not require knowledge of stochastic programming in general but illustrates one particular aspect of this discipline, that of ‘‘scenario planning.’’ The model is tested by managing a hypothetical portfolio of municipal bonds within the environment of historical interest rates. 14.1 OVERVIEW OF PORTFOLIO PLANNING The bond-portfolio management problem can be viewed as a multiperiod decision problem under uncertainty, in which portfolio decisions are periodically reviewed and revised. At each decision point, the portfolio manager has an inventory of securities and funds on hand. Based on present credit-market conditions and his assessment of future interest-rate movements and demand for funds, the manager must decide which bonds to hold in the portfolio over the next time period, which bonds to sell, and which bonds to purchase from the marketplace. These decisions are made subject to constraints on total portfolio size, exposure to risk in the sense of realized and unrealized capital losses,∗ and other policy limitations on the makeup of the portfolio. At the next decision point, the portfolio manager faces a new set of interest rates and bond prices, and possibly new levels for the constraints, and he must then make another set of portfolio decisions that take the new information into account. ∗ Realized capital losses refer to actual losses incurred on bonds sold, while unrealized capital losses refer to losses that would be incurred if bonds currently held had to be sold. 465 466 A System for BankPortfolio Planning 14.1 Figure 14.1 (Typical yield curve for good-grade municipal bonds. Before describing the details of the portfolio-planning problem, it is useful to point out some of the properties of bonds. A bond is a...

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