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-/ + 301
CONCEPT OF ALM
( ALM is of greatest interest to depository institutions,
nonbank financial corporations, and multinational
corporations.
( Both the depository institutions and nonbank corporations
are primarily concerned with the return on their portfolios
and the risk associated with the portfolios.
( The main objective of ALM is to manage Net interest
margin.
( The net difference between interest earning assets (loans)
and interest paying liabilities (deposits) to produce
consistent growth in the loan portfolio and shareholder
earnings, regardless of short-term movement in interest
rates.
( Net interest income = (interest revenue ² interest expense)
( Fixed Rate Investment funded by Floating Rates
can create problem
( Alm also include techniques for managing
exchange-rate risk.
EVOLUTION OF ALM
( The ALM, historically, has evolved from the early
practice of managing liquidity on the bank·s asset
side, to a later shift to the liability side.
( A still later realization of using both the assets as
well as the liabilities side of the balance sheet to
achieve optimum resources management, i.e., an
integrated approach.
( Initialy most sources of funds were core deposits
which were quite impervious to interest rate
movements in this environment bank fund
management concentrate on the control of assets
( 'ith liability management, banks now have two
sources of funds ² core deposits and purchased
funds ² with quite different characteristics.
( The bank can be thought of as a price taker in
the purchased funds market whereas in the core
deposit market it can be viewed as a price setter.
( The recent volatility of interest rates broadened
to include the issue of credit risk and market risk
The function of asset-liability management is to
manage and control three types of risks:-
( Interest rate risks-The pricing difference between
loans and deposits.
( Credit risk-The probability of default in the
system.
( Liquidity risk-'hen loan and deposits have
different maturities.
THE FOUNDATION CONCEPTS
( Liquidity
( Term Structures

( Interest rate senstivity

( Maturity compositions

( Default risks
 LIQUIDITY
( Ease with which asset can be converted into cash

( Two aspects of liquidity as the term pertains to assets are

maturity liquidity & marketability.

( There is a trade off between liquidity and profitability.

TERM STRUCTURE
( Relationship between debt instruments yield and
maturities known as yield curve.
( These relationships can be drawn for any group
of securities having similar credit ratings
( The shape of the yield curve and expectations
about its future shape helps in developing ALM
strategies.
INTEREST²RATE SENSITIVITY
( 3 ways to look at this

( The degree to which an instrument ¶s price will

change when the instrument ¶s yield changes.

( As the market rate changes, the return on the

interest-sensitive assets and the cost of the
interest-sensitive liabilities also changes.

( The degree to which an instrument·s interest rate

adjusts and the speed of this adjustment.
MATURITY COMPOSITION

( The maturities of assets and liabilities can be

matched or unmatched.
( If the maturity and the interest-rate senstivity of
an asset and a liability are matched, then the
institution has a spread lock on that portion of
the principals that are also matched.
( Suppose that a bank holds $8 million of a three-
year fixed rate asset returning 14%.These assets
are funded by $6 million of a three-year fixed rate
liability , having a cost of 12%, and $2 million of
three month CDs. The bank has a spread lock on
$6 million of assets with a spread of 2%.
DEFAULT RISK
( It is the risk that the debtor will be unable to
repay the loan principal and/or interest.

( Every commercial bank, serve a very useful

function in evaluating borrower risks and in
pooling those risks.
M
  
   M
M

( Techniques for assessing asset-liability risk came to
include Gap Analysis and Duration Analysis
( Both approaches worked well if assets and liabilities
comprised fixed cash flows. But cases of callable
debts, home loans and mortgages which included
options of prepayment and floating rates, posed
problems that gap analysis could not address
( Duration analysis could address these in theory, but
implementing sufficiently sophisticated duration
measures was problematic
( Apart from these two techniques, Total return
optimization and risk controlled arbitrage will be
covered.
mm
m 
( Gap may be defined as
÷ the dollar difference between financial institution·s
floating rate assets and floating rate liabilities
÷ The dollar difference between an institution·s fixed
rate assets and fixed rate liabilities

Best understood as a balance sheet concept

 DOLLAR GAP
"- '6 37  
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DOLLAR GAP
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EFFECT OF INTEREST RATE CHANGES
ON DOLLAR GAP

  @  -/@

Positive RSA$>RSL$ Rise Rise
(Asset) Fall Fall
Negative RSA$<RSL$ Rise Fall
(Liability) Fall Rise
Zero RSA$=RSL$ Rise No effect
Fall No effect
INTEREST RATE RISK
Unexpected changes in interest
rates can significantly alter a
bank·s profitability and market
value of equity.
 FIGURE 8-1
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INTEREST RATE RISK
( Reinvestment rate risk
- Cost of funds vs. return on assets.
=> Funding GAP, impact on NII.
( Price Risk
- Change in interest rates will
cause a change in the value (price) of
assets and liabilities.
- Longer maturity (duration) -- >
larger change in value for a given change
in interest rates.
=> Duration GAP, impact on
market value of equity.
FUNDING GAP:
FOCUS ON MANAGING NII IN THE SHORT RUN.
( Method

Group assets and liabilities into time

"buckets" according to when they
mature or re-price.
Calculate GAP for each time bucket
Funding GAPt = $ Value RSAt - $ Value
or RSLt where t = time bucket; e.g., 0-3
months.
FACTORS AFFECTING NII.
Changes in the level of interest rates.
rNII = (GAP) * (riexp.)
Changes in the volume of assets and liabilities.
Change in the composition of assets and
liabilities.
Changes in the relationship between asset yields
and liabilities cost of funds.
 EXAMPLE
*


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EXAMPLE
A. 1% increase in the level of all short-term
rates.
B. 1% decrease in spread between assets yields
and interest cost.
â RSA increase to 8.5%
â RSL increase to 5.5%
C. Proportionate doubling in size.
D. Increase in RSAs and decrease in RSL·s
â RSA = 540, fixed rate = 310
â RSL = 560, fixed rate = 260.
 A. 1% INCREASE IN SHORT-TERM RATES
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 B. 1% DECREASE IN SPREAD
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 C. PROPORTIONATE DOUBLING IN SIZE
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D. INCREASE IN RSAS AND DECREASE IN RSLS
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EFFECT OF INTEREST RATE CHANGES
ON DOLLAR GAP

  @  -/@

Positive RSA$>RSL$ Rise Rise
(Asset) Fall Fall
Negative RSA$<RSL$ Rise Fall
(Liability) Fall Rise
Zero RSA$=RSL$ Rise No effect
Fall No effect
NET INTEREST MARGIN
The change in dollar amount of
net interest margin (rNIM) is:

ǻNIM
RSA$ ri  RSL$ ri 
Gap
ri 

NET INTEREST MARGIN

An increase in interest rates adversely

affects NIM because there are more RSL$
than RSA$

I S $
i ö S $
i  ap

i 



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ö

:
( Õ
  
 measure the gaps for different
maturity ´bucketsµ (e.g., 0-7 days, 8-30 days, 31-90
days, and 91-365 days).

( @    
 add up the incremental gaps from
maturity bucket to bucket.
EXAMPLE
7 7 7 7

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RATE SENSITIVITY REPORTS
( Periodic GAP
÷ Gap for each time bucket.
÷ Measures the timing of potential income
effects from interest rate changes.
( Cumulative GAP
÷ Sum of periodic GAP's.
÷ Measures aggregate interest rate risk over the
entire period.
( Examine Exhibit 8.5:
 !8
8
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 MANAGING INTEREST RATE RISK 'ITH DOLLAR
GAPS

( "/3/': To guard
against changes in NIM (e.g., near zero gap).

( m'' 3/':

To seek to increase NIM in conjunction

with interest rate forecasts
(e.g., positive or negative gaps).
AGGRESSIVE FUND MANAGEMENT

( Forecasts important to bank strategy

÷ If interest rates are expected to increase in the

near future, the bank can exploit a positive
dollar gap.

÷ If interest rates are expected to decrease in the

near future, the bank could exploit a negative
dollar gap (as rates decline, deposit costs fall
more than interest income, increasing profit).
PROBLEMS 'ITH DOLLAR GAP
MANAGEMENT

( Time horizon problems related to when assets

and liabilities are repriced.

( Assumed correlation of 1.0 between market

rates and rates on assets and liabilities

( Focuson net interest income rather than

shareholder wealth.
DURATION
A measure of the maturity and value
sensitivity of a financial asset that
considers the size and the timing of all
its expected cash flows.
DURATION GAP MODEL (DAGAP)
( Duration is defined as the average life of a
financial instrument.
( It also provides an approximate measure of
market value interest elasticity.
( DGAP directly indicates the effect of interest rate
changes on the net worth of the institution.
DURATION GAP
( Focus on managing NII or the market
value of equity, recognizing the timing of
cash flows
( Interest rate risk is measured by
comparing the weighted average duration
of assets with liabilities.
( Asset duration > Liability duration

È Interest rates

Market value of equity falls
( " - -/3 '(*%
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CALCULATING DURATION
( Step 1: Identify Interest rate sensitive assets
and liabilities. Additionally, non ² interest rate
bearing items can also be included in calculation.
( Step 2: Calculate the MTM value for all the rate
sensitive assets.
( Step 3: Calculate the MTM value for all the rate
sensitive liabilities.
( Step 4: Calculate the duration for each asset and
liability of the on-balance sheet portfolio. This is
calculated using Macaulay Duration.
MACAULAY DURATION

 
p
 
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 MACAULAY DURATION


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CALCULATING DURATION
Step 5: Calculate the aggregate weighted average
duration of assets and liabilities.
'eighted Average Duration of Assets (DA) = 'aDa
'eighted Average Duration of Liabilities (DL) = 'lDl
'here,
' a = market value of the asset ¶a·(MTM) divided by
market value of all the assets (Net MTM)
' l = market value of the liability ¶l·(MTM) divided by
the market value of all the liabilities (Net MTM)
Da = duration of asset ¶a·
Dl = duration of liability ¶l·
CALCULATING DURATION
Step 6: Calculate the duration GAP using the
following formula:
"m6"m7 "B  m
'here,
DA is the weighted average duration of assets,
DL is the weighted average duration of liabilities,
MVL is the total MTM of liabilities,
MVA is the total MTM of assets.
MODIFIED DURATION
( Modified duration is a measure of the price
sensitivity of a bond to interest rate movements.
It is calculated as shown below:
Modified Duration = Macaulay Duration /( 1 +
y/n), where y = yield to maturity and n = number
of discounting periods in year ( 2 for semi - ann
pay bonds )
Then, % Price Change = -1 * Modified Duration *
Yield Change
Ú
  

 
  


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( In the previous example, The bond was repriced
for an increase and decrease in rates of 2.5%.
( The Modified Duration for this bond will be:
Dmod = -1 * 4.26 / (1 + .075/2) = 4.106 years.
( Therefore, a change in the yield of +/- 2.5%
should result in a % change in the price of the
bond of:
-/+ 4.106 * .025 = +/- 0.10265 (+/- 10.265 %).
( Since the bond was initially priced at par, the
estimated prices are : $110.27 at 5.00% and
$89.74 at 10.00%.
DURATION GAP MANAGEMENT

( Defensive
÷ Immunize net worth of bank
÷ Duration gap ~ 0

( Aggressive
÷ Use forecast of interest rate changes to manage bank net
worth
DURATION GAP HEDGING
( Positive gap
÷ Reduce duration of assets
÷ Increase duration of liabilities
÷ Short position in financial futures

( Negative gap
÷ Increase duration of assets
÷ Decrease duration of liabilities
÷ Long position in financial futures
PROBLEMS 'ITH DURATION GAP

÷ Overly aggressive management ´bets the bank.µ

÷ The application of duration analysis requires extensive
data on the specific characteristics and current market
pricing schedules of financial instruments.
÷ Duration analysis assumes (1) that the yield curve is flat
and (2) shifts in the level of interest rates imply parallel
shifts of the yield curve.
÷ Average durations of assets and liabilities drift or change
over time and not at the same rates (duration drift).
Rebalancing can help to keep the duration gap in a target
range over time.
OTHER ISSUES IN GAP ANALYSES

( Simulation models

÷ Examine different ´what ifµ scenarios about interest rates

and asset and liability mixes in gap management -- 
 shows impacts on income and net worth.

( Correlation among risks

÷ Gap management can affect credit risk. For example, if a

bank decides to increase its use of variable rate loans (to
obtain a positive dollar gap in anticipation of an interest
rate increase in the near future), as rates do rise, credit
risk increases due to fact that some borrowers may not be
able to make the higher interest payments.

÷ Gap management may make the bank less liquid.

THE INVESTMENT BANKER IN ASSET /LIABILITY
MANAGEMENT

( In an effort to carve out new product niches, a number

of investment banks developed strategies to assist
financial institutions in the management of their
portfolios.
( Most of these strategies were developed in the late
1980s.
THE INVESTMENT BANKER IN ASSET /LIABILITY
MANAGEMENT

( There were strategies that were marketed under the

general umbrella of asset /liability management
techniques. Two of them are discussed below: -
( 1. Total return optimization

( 2. Risk controlled arbitrage

!m
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! Cm!

( Total Return Optimization employs tools from

the management sciences, such as  

  , in an effort to determine the
optimal mix of assets given a set of constraints
and a variety of yield curve projections.
TOTAL RETURN OPTIMIZATION

( In total return optimization strategies, the total

return to be maximized consists of the interest
(coupons), the reinvestment income, and the
change in market value of the assets. The
constraints, sometimes called portfolio attributes,
can include such things as liquidity
requirements, durations, industry sector
specifications, default risk level, tax treatment of
income, and obligation to hold minimum
quantities of specific entities· debt.
( Let us consider an example. Suppose that a client
has five debt securities available to include in
portfolio. These are
( (1) Treasury bills,

( (2) Treasury bonds,

( (3) State bonds,

( (4) Local municipal bonds,

( (5) Corporate bonds.



    .
   .    .

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For this example, we will treat applicable tax rates as

though they are additive. For example, if the interest
income is subject to both federal and state taxes, then
the applicable tax rate is 26% plus 12% plus 3% for a
total of 41%.
( If there were no constraints on our selections, we would
simply calculate the after tax rate of return on each
security and then commit all the clients funds to that
one security. But, as it happens, there are number of
constraints. Suppose, for example,
( No more than 32% of the portfolio can be invested in
any one security but at least 12% should be invested in
T- bills.
( Secondly, no more than 50% can be invested in state
and local securities combined.
( Thirdly, the portfolio·s duration cannot exceed 7.2.
( Fourth, the weighted average term to maturity cannot
exceed 12.
( Finally, the portfolio weights must sum to unity and
short positions are not permitted.


 1!   !  . 
   

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)   ,2((0 &,0 +23+40 '2( '2(

&   -2*'0 &,0 ,233&0 323 )32(

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+ 
  42,(0 '0 42,('0 (2, 42*

( /  )&2++0 +)0 42*+'0 42, &+2+

This particular problem can be solved by linear programming.

The total of ten constraints are there according to the conditions specified.
The equation becomes:

Maximize rp= 4.847 w1 + 6.882 w2 + 8.051 w3 + 7.650 w4 + 7.340 w5

Subject to:
( 1.00 w1 +0.00 w2 + 0.00 w3 + 0.00 w4 + 0.00 w5 < 0.32
( 0.00 w1 +1.00 w2 + 0.00 w3 + 0.00 w4 + 0.00 w5 < 0.32
( 0.00 w1 +0.00 w2 + 1.00 w3 + 0.00 w4 + 0.00 w5 < 0.32
( 0.00 w1 +0.00 w2 + 0.00 w3 + 1.00 w4 + 0.00 w5 < 0.32
( 0.00 w1 +0.00 w2 + 0.00 w3 + 0.00 w4 + 1.00 w5 < 0.32
( 1.00 w1 +0.00 w2 + 0.00 w3 + 0.00 w4 + 0.00 w5 < 0.12
( 0.00 w1 +0.00 w2 + 1.00 w3 + 1.00 w4 + 0.00 w5 < 0.50
( 0.50 w1 +8.80 w2 + 9.90 w3 + 5.60 w4 + 7.60 w5 < 7.20
( 0.50 w1 +18.50 w2 + 19.40 w3 + 7.30 w4 + 24.40 w5 < 1.00
And
( w1 , w2 , w3 , w4 , w5 > 0
( Using a linear programming software we get following
result


   
  )42*0
  *&0

  )30

  *&0
/  '240

( Using the weights above and assuming the yield curve

projections proves correct, the weighting scheme above
yields an after tax return of 6.989 %. No other combination
can yield more return and satisfy all of the constraints
simultaneously
RISK CONTROL ARBITRAGE
( Risk control arbitrage is an effort to maximize
the interest spread by purchasing high yield
assets and funding these assets at the lowest
possible cost.
( The funding source will usually be repo market
or fed funds as these are usually the cheapest
sources for borrowers in a position to use these
markets. The strategy would employ a swap to
convert the floating rate of the repo liabilities to a
fixed rate liability which closely matches the
character and the principle of the assets.
The institution engages in a reverse repo to secure
funding ( 30 or 90 days term repos are most common).
The funds obtained are used to purchase the higher
yielding assets. The institution now enters the fixed for
floating interest rate swap with itself as fixed rate
payer. The floating rate of the swap is tied to the repo
rate or some other short term rate( Say one month or
three month LIBOR).
CONCLUSION
( ALM has evolved since the early 1980's. Today,
financial firms are increasingly using market value
accounting for certain business lines. Techniques of
ALM have also evolved. The growth of OTC derivatives
markets has facilitated a variety of hedging strategies.
( Thus, the scope of ALM activities has widened. Today,
ALM departments are addressing (non-trading)
foreign exchange risks as well as other risks. Also,
ALM has extended to non-financial firms.
( Corporations have adopted techniques of ALM to
address interest-rate exposures, liquidity risk
and foreign exchange risk. They are using related
techniques to address commodities risks. For
example, airlines' hedging of fuel prices or
manufacturers' hedging of steel prices are often
presented as cases of ALM. Thus it can be safely
said that Asset Liability Management will
continue to grow in future and an efficient ALM
technique will go a long way in managing
volume, mix, maturity, rate sensitivity, quality
and liquidity of the assets and liabilities so as to
earn a sufficient and acceptable return on the
portfolio.
REFERENCES
( Marshall, J.F. & Bansal, V.K.(2010). v 

   . Phi Learning Private Ltd.: New
Delhi.
( Khan, M.Y. Asset Liability Management

( m   m   , Oracle

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