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7/31/2019 6.Tools and Techniques
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Tools and Techniques
TOOLS OF ALM
Techniques for assessing asset-liability risk includes Gap Analysis and Duration
Analysis. These facilitated techniques of managing gaps and matching duration of
assets and liabilities. 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. Accordingly, banks and insurance companies started using
Scenario Analysis.
Under this technique assumptions were made on various conditions, for example: -
Several interest rate scenarios were specified for the next 5 or 10 years.
These specified conditions like declining rates, rising rates, a gradual
decrease in rates followed by a sudden rise, etc. Ten or twenty scenarios
could be specified in all.
Assumptions were made about the performance of assets and liabilities
under each scenario. They included prepayment rates on mortgages or
surrender rates on insurance products.
Assumptions were also made about the firm's performance-the rates at
which new business would be acquired for various products, demand for the
product etc.
Market conditions and economic factors like inflation rates and industrial
cycles were also included.
QUANTITATIVE ANALYSIS:
Quantitative analysis can assists in determining the level of exposure. Examiners
should perform this analysis as a part of each exam. Ratios and trends are the
focus of quantitative analysis. The following ratios are used to assists the
examiners to examine the ALM position.
Net Loans/ Total Assets : This ratio measures the percentage of total
assets that are invested in loan portfolio. Management should haveestablished a maximum goal ratio to avoid liquidity problem.
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Core deposit ratio: This ratio is used to identify stable deposits that the
company can rely on ,rather than seasonal swing, which can be used to
fund long term assets. The more stable the fund, the easier it is to control
liquidity and ALM. Therefore a high percentage is desirable and indicates a
solid company.
Liquid assets/Total assets: This ratio measures the percentage of total
assets that are invested in liquid assets. Liquid assets often pay no interest
or have a lower yield because there is very little risk. Only enough funds to
meet liquidity needs should be maintained in liquid assets.
Liquid assets- Short term Payables/Member Deposits: The adequacy
of the companys liquid cash reserves to satisfy clients savings withdrawal
after paying all immediate obligations is measured by this ratio. The goal is
to have just enough liquid funds to meet all member requests and
operating expenses, with any excess funds invested in interest bearing
accounts.
Loan Turnover ratio: This ratio estimates how quickly the company will
convert the loan portfolio into cash. The lower the result the faster the loan
portfolio matures. ALM should be easier because the loan portfolio
repayment is high, thus allowing management access to fund to provide for
sufficient liquidity and funding of new loans and investment. The examinerscan also analyze the changes to the ratio over various timeframes, this
would provide an indication of the effect of recent decisions on the average
term of the loan portfolio.
External Credit/Total Assets: This ratio measures the level of external
credit. Examiners should ensure that the credit union is not dependent on
external sources to fund normal daily operations and long term needs;
external credit should be used only to fund short-term liquidity shortfalls.
Net Interest margin: This calculation begins with gross income and
determines the amount available to cover operating expenses and
contributions to capital after all interest and dividends on savings have
been paid. Management should determine the minimum net interest
margin that must be maintain in order to meet all operating expenses and
capital contributions. Analyzing the net interest margin trend provides
insight to the effect of managements past pricing decision.
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GAP ANALYSIS: It is the tool that helps the company to compare its actual
performance with its potential performance. The goal of gap analysis is to identify
the gap between the optimizedallocation and integration of the inputs, and the
current level of allocation. This helps provide the company with insight into areas
which could be improved. The gap analysis process involves determining,
documenting and approving the variance between business requirements and
current capabilities. Gap analysis naturally flows from benchmarking and other
assessments. Once the general expectation of performance in the industry is
understood, it is possible to compare that expectation with the company's current
level of performance. This comparison becomes the gap analysis. It measures at a
given date the gaps between rate sensitive liabilities (RSL) and rate sensitive
assets (RSA) (including off-balance sheet positions) by grouping them into time
buckets according to residual maturity or next repricing period, whichever is
earlier. An asset or liability is treated as rate sensitive if i) within the time bucket
under consideration, there is a cash flow; ii) the interest rate resets/reprices
contractually during the time buckets; iii) administered rates are changed and iv)
it is contractually pre-payable and withdrawal allowed before contracted
maturities. Thus,
GAP= RSA RSL
GAP RATIO= (RSA - RSL)/Total Assets
Gap analysis is performed on a spreadsheet. The assets and liabilities are assignedto time periods (0-1 years, 1-2 years, etc) based on their maturities. This is
relatively simple for components in which the amount matures on a specific date.
But more complex if RSA & RSL does not have a stated maturity such as death
claims.
http://en.wikipedia.org/wiki/Operations_researchhttp://en.wikipedia.org/wiki/Resource_allocationhttp://en.wikipedia.org/wiki/Benchmarkinghttp://en.wikipedia.org/wiki/Operations_researchhttp://en.wikipedia.org/wiki/Resource_allocationhttp://en.wikipedia.org/wiki/Benchmarking7/31/2019 6.Tools and Techniques
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Gap analysis also considers the reprising opportunities of the assets and liabilities.
When all or part of the assets and liabilities will be available for reinvesting at the
prevailing interest rates. The culmination of the analysis is the:
Gap or the total of RSAs-RSLs for each time frame; and
Gap ratio, which divides the above result, or gap by total assets. The gap
ratio puts the gap in perspective to the companys size.
The gap and gap ratio can be positive, negative and zero. A credit union with a
positive gap assumes a more asset sensitive position .In a positive gap in the
given time band, an decrease in market interest rate my lead to a increase in Net
Interest Income With a negative gap , RSLs are repricing more quickly than RSAs
within the time period. If a negative gap occurs in a given time band, an increase
in market interest rate could cause a decline in Net Interest Income. A gap of
zero indicated that RSAs and RSLs for the time period are evenly matched.
1-14Days
15-29Days
30Days-3Month
3 Mths -6 Mths
6 Mths -1Year
1Year -3 Years
3 Years- 5Years
Over 5Years
Total
Capital 200 200
Liab-fixed Int 300 300 200 600 600 300 200 200 2600
Liab-floating Int 350 400 350 450 500 450 450 450 3400
Others 50 50 200 300
Total outflow 700 750 550 1050 1100 750 650 1050 6500
Investments 200 150 250 250 300 100 350 900 2500
Loans-fixed Int 50 100 0 100 150 50 100 100 600
Loans - floatingint
300 300 400 650 500 650 150 150 3100
Others 50 50 200 300
Total Inflow 600 550 650 1000 950 800 600 1350 6500
Gap -100 -100 100 -50 -150 50 -50 300 0
Cumulative Gap -100 -200 -100 -150 -300 -250 -300 0 0Gap Ratio -14.29 -15.38 18.18 -4.76 -13.64 6.67 -7.69 28.27 0
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The limitations of gap analysis are as follows:
The gap ratio assumes that all rate sensitive accounts re-price
equally.
It is not useful in determining how RSAs and RSLs should be
positioned with regards to maturity to maximize profitability.
It is similar to a balance sheet as it is only a snapshot in time, it does
not measure the effect of multiple interest rate changes over time
and
It relies heavily on the assumptions that were used to create the
report, if the assumptions are incorrect, then the information is not
useful.
DURATION ANALYSIS: Duration measures the average time to maturity, using
discounted cash flows as the weights, associated with a particular investment
instrument or portfolio, usually a bond or group of bonds. It can be shown that
duration so defined also approximately equals the units of change in the market
value of a portfolio of assets and liabilities that would arise from a unit parallel
shift in the market yield curve). The unit of duration under this second definition is
value per interest rate, but as interest rate is value per time, duration is also
expressed as units of time.
Duration matching uses asset allocation to hedge the portfolio against parallel
shifts in the yield curve; that is, interest rate (or reinvestment rate) risk.
Specifically, if liabilities are discounted by current interest rates, then, if all else is
equal, the value of the liabilities will decrease as interest rates increase. The bond
market values also will decrease. Thus, surplus is potentially insulated. Managing
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the duration of the assets in this way immunizes the portfolio of assets and
liabilities against this form of interest rate risk.
CALCULATING DURATION ON Rs 1000 TEN YEAR 10% COUPON
BONDWHEN INTEREST RATE IN 10%
YEAR CASHPAYMENTS(ZEROCOUPON BONDS)
PRESENTVALUE OFCASHPAYMENTS
WEIGHTS (%OF TOTALPV=PV/RS1000)
WEIGHTEDMATURITY1x4/100YEARS
1 100 90.91 9.091 0.090912 100 82.64 8.264 0.165283 100 75.13 7.513 0.225394 100 68.30 6.830 0.27320
5 100 62.09 6.209 0.310456 100 56.44 5.644 0.338647 100 51.32 5.132 0.359248 100 46.65 4.655 0.373209 100 42.41 4.241 0.3816910 100 38.55 3.855 0.3855010 1000 385.54 38.554 3.85500
DUR=
To get the effective maturity of the set of zero-coupon bonds, we add up the
weighted maturities in column (5) and obtain the figure of 6.76 years. This figure
for the effective maturity of the set of zero-coupon bonds is the duration of the
10% ten-year coupon bond because the bond is equivalent to this set of zero-
coupon bonds. In short, we see that duration is a weighted average of the
maturities of the cash payments.
If we calculate the duration for an 11-year 10% coupon bond when the interestrate
is again 10%, we find that it equals 7.14 years, which is greater than the 6.76
years for the ten-year bond. Thus we have reached the expected conclusion: All
else being equal, the longer the term to maturity of a bond, the longer its duration.
All else being equal, when interest rates rise, the duration of a coupon bond falls.
The duration of a portfolio of securities is the weighted average of the durations of
the individual securities, with the weights reflecting the proportion of the portfolio
invested in each.
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To summarize, our calculations of duration for coupon bonds have revealed four
facts:
The longer the term to maturity of a bond, everything else being equal, the
greater its duration.
When interest rates rise, everything else being equal, the duration of a
coupon bond falls.
The higher the coupon rate on the bond, everything else being equal, the
shorter the bonds duration.
The duration of a portfolio of securities is the weighted average of the
durations of the individual securities, with the weights reflecting the
proportion of the portfolio invested in each.
Now that we understand how duration is calculated, we want to see how it can be
used by managers of financial institutions to measure interest-rate risk. Duration is
a particularly useful concept, because it provides a good approximation,
particularly when interest-rate changes are small, for how much the security price
changes for a given change in interest rates.
The greater the duration of a security, the greater the percentage change in the
market value of the security for a given change in interest rates. Therefore, the
greater the duration of a security, the greater its interest-rate risk.
% P= -DUR x ( i/1+t)
Application
A pension fund manager is holding a ten-year 10% coupon bond in the funds
portfolio and the interest rate is currently 10%. What loss would the fund be
exposed to if the interest rate rises to 11% tomorrow?
Solution
The approximate percentage change in the price of the bond is 26.15%. As the
calculation in the table above shows, the duration of a ten-year 10% coupon bond
is 6.76 years.
Therefore,
% P= -6.15%
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The greater the duration of a security, the greater the percentage change in the
market value of the security for a given change in interest rates. Therefore, the
greater the duration of a security, the greater its interest-rate risk.
SCENARIO ANALYSIS: Scenario analysis is the process of forecasting the likely
outcomes of future events by following a variety of possible scenarios. It is the
formalized process of what if analysis that in reality has always been part of
business decision-making. The objective of scenario analysis is to improve
decision-making by analyzing possible outcomes and their implications.
Financial scenario analysis is thought have originated in banks and insurance
companies in the 1970s and 1980s, when interest rate volatility began to
constitute a threat to balance sheets. Today, financial institutions use scenario
analysis in asset liability management and corporate risk management, and it
remains the primary tool for analyzing interest rate risk. Businesses use scenario
analysis for the analysis of a number of risks.
A financial institution may use scenario analysis to forecast what might happen to
the economy by following various paths (e.g. rapid growth, slow growth, slowdown,
recession), and what might happen to financial market returns, such as bonds,
stocks, or cash, in each of those economic scenarios. The scenarios may have sub-
scenarios, and probabilities may be assigned to each. Such analysis will help the
institution to determine how to distribute its assets between asset types, and from
this it can calculate a scenario-weighted expected return to help demonstrate the
attractiveness of the financial environment.
A scenario is usually specified as a set of paths that will be determined by risk
factors. Typically, in financial matters these risk factors include interest rates,
exchange rates, equity prices, commodity prices, and implied volatilities.
Outcomes can be modeled mathematically or statistically, and the figures can be
put through a spreadsheet program or other modeling software.
Financial scenario analysis usually seeks to estimate a portfolios value in a worst-
case situation. Different reinvestment rates for expected returns which are then
reinvested during the period are calculated using scenario analysis. This may be
approached in many ways, but usually the standard deviation of daily or monthly
returns on securities is determined, and the value of the portfolio is calculated
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assuming that each security has given returns two or three standard deviations
above or below the average return.
Thus an analyst will have reasonable certainty that the value of a portfolio is
unlikely to drop below (or increase above) a certain value during a given time
period.
With scenario analysis, several interest rate scenarios would be specified for the
next 5 or 10 years. These might specify declining rates, rising rate's, a gradual
decrease in rates followed by a sudden rise, etc. Scenarios might specify the
behavior of the entire yield curve, so there could be scenarios with flattening yield
curves, inverted yield curves, etc. Ten or twenty scenarios might be specified in
all. Next, assumptions would be made about the performance of assets and
liabilities under each scenario. Assumptions might include prepayment rates on
mortgages or surrender rates on insurance products. Assumptions might also be
made about the firm's performancethe rates at which new business would be
acquired for various products. Based upon these assumptions, the performance of
the firm's balance sheet could be projected under each scenario. If projected
performance was poor under specific scenarios, the ALM committee might adjust
assets or liabilities to address the indicated exposure. A shortcoming of scenario
analysis is the fact that it is highly dependent on the choice of scenarios. It also
requires that many assumptions be made about how specific assets or liabilities
will perform under specific scenarios.
MODEL FORMULATION
Based on the description of the characteristics of the particular life insurance
policy of the Company, a multi-stage stochastic linear programming model was
developed. Since a common reserve is kept for risk as well as savings component,
a common liability account has been taken in the model for keeping track of total
reserve. The company does not promise any return on the savings component.
Instead, at the maturity, it simply refunds the total premium deposited. Hence
there was no need to model separately an account for interest earned by policy
holders on their premiums. Only the principal account has to be maintained which
carries the total premium deposited till date. As assumed earlier proportion of the
net profit earned by the Company in a year is declared as bonus to the
shareholders but it is paid only at the time of maturity. Hence, every year the
bonus given to the policyholders is added to the principal reserve which would
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have to be repaid at the time of maturity. Here we are assuming that the bonus
earned by the policyholders in a year would also earn them income in subsequent
years since the bonus declared today would be paid only at the time of maturity.
Lastly, since no differentiation is made between the income return and the price
return on an asset, we model only the total return on an asset.
The challenge for any company is to make prudent investments of its premium in
the two asset classes such that at all points in time in future, the total cash inflows
are able to meet the expected outflows due to maturity, death claims, commission
and other expenses. The cash inflows would be due to the premium and income
earned from the investments made in the previous years in the two asset classes.
The return on assets would depend on the possible scenarios, that exist in future.
While theoretically, there can be infinite scenarios, a finite number of scenarios,
along with probability for each scenario, can be defined based on past trends.
While even the liabilities and other parameters like premium income are stochastic
in nature and can be assumed to be scenario dependent, for the purpose of
keeping the model within prudent limits of complexity, we model only the return
on assets to be scenario dependent. Figure below gives an illustration of a typical
scenario tree.
The objective is to maximize the expected net worth (policyholders and
shareholders reserves) of the firm at the horizon period while matching the cash
inflows with the cash outflows at all nodes in the scenario tree
We define the following notations used in the model:
The set of scenarios (S) is indexed by
the set of time period (I) is indexed by i.
Parameters:
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pi is the probability of the scenario for a given year i
Li is the total (principal & interest liability of policyholders accounts)
reserve at the end of year i and scenario ,
Gi is the total value of the shareholders account at the end of year i and
scenario
Di is the total income earned in the year i under scenario
ui is the shortfall of income over commission and other expenses
vi is the surplus of income over commission and other expenses
Fi is the premium inflow in the year i
Mi, is defined as the maturity outgo in the year i ( it may be noted that
maturity claims denote only the refund of the principal savings component
without including the share in the bonus returned to the policy holder at the
time of maturity)
Yi is the death claims in the year i
Si is the surrender outgo in the year i
Ci is the commission expense in the year i
Ei is other expenses (operating, etc.) incurred in the year i
Variables :
X1iis the allocation made from the policyholders account to asset 1 (here
asset 1 is assumed to be equity) at the end of year i and scenario
X2i is the allocation made from the policyholders account to asset 2 (here,
asset 2 is assumed to be debt) at the end of year i and scenario ,
X^G1i is the allocation made from the shareholders account to asset 1
(equity) at the end of year i and scenario
X^G2i is the allocation made from the shareholders
account to asset 2
(debt) at the end of year i and scenario .
R1 is the return earned on asset 1 under scenario
R2 is the return earned on asset 2 under scenario
u1 is the shortfall of income (from investments made in previous year) at
the end of year i and scenario over commission and other expenses
v1 the surplus of income (from investments made in previous year) at the
end of year i and scenario over commission and other expenses.
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as defined earlier, is the proportion of the profits passed on to the
policyholders as bonus (we assume = 0.9) and T is the horizon year at
which the expected net worth of the firm is to be maximized.
Also, r is taken as the cost of capital of shareholders.
Thus, the objective function is defined as:
Objective Functions:
Maximize:
Constraints:
The liabilities and other parameters need to be modeled using their expected
values as estimated by the company. Based on market trends, certain standards
norms in insurance business (like mortality tables) and statistical analysis, a
company can have a prior estimate of the premium inflows (F), maturity claims
(M), death claims (Y), surrender outgo (S), commission expenses (C) and other
expenses (E) for the next few years (life of the policy).
Total Income Earned:
For a particular scenario , the total income earned in policyholders account in
year I is
Di = r1X1(i-1, ) + r2X2(i-1, )
where is the scenario that occurred in the year i-1
Income Constraints:
Here,
Uiis funded from the shareholders account G.
On the other hand,
Viis shared between the policyholders and the shareholders in the ratio
and (1- ) respectively.
Di + ui - vi = Ci +Ei
Total Reserve Constraints:
This surplus declared as bonus to policyholders is not paid in the current year but
at the maturity. Therefore, this surplus should be added to the total reserve.
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Hence the total reserve at the end of year i is given by,
The above equation takes care of the reserve constraint, that is, at any period in
future for any possible scenario, the total value of the reserve should be greater
than the payouts due to maturity, death claims and surrender. Here, M signifies
only the principal maturity amount. The income surplus ( *v i) during the tenure of
policy is added to policyholders account and is repaid at the time of maturity. Here
we assumed that the policy is for 10 years and hence the policyholder receives notjust the total premium deposited (M), but also the average return on the premium
in ratio of total income surplus to the total premium collected in last 10 years (life
of the policy).
Hence, we have the term 1- of surplus income vi is the net gain of the
shareholders. On the other hand, if an income shortfall ( ui ) occurs in the
policyholders account, that shortfall in policyholders account should be met by
withdrawing the equivalent amount from shareholders account.
Total value of shareholders
The total value of shareholders account, at any cost, must be greater than the
income shortfall; thus the shareholder reserve constraint is defined as:
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Also, the value of the shareholders account at the end of year i at scenario
would be given by
Allocations:
Finally, with respect to the allocations - at the end of year i under the scenario ,
the allocations of the amount in policyholders account and shareholders account
to assets 1 and 2 are made as,
Sum of Probabilities
Sum of probabilities in all scenarios will be one,
This way the value of the policyholders
account and shareholders account arederived for each of the scenarios for every year till horizon period and
subsequently the allocation amounts in various asset classes are decided. Finally,
determining the probability of each scenario at the horizon period, the expected
value of the firm (sum of value of the policyholders account and shareholders
account) can be calculated. The objective is to maximize the expected total worth
of the firm (policyholders plus shareholders account) at the horizon period while
penalizing for every shortfall ( ui) that occurs in all the intermediate periods.
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Analysis of the financial performance:
The financial performance of the company can be measured through ratio
analysis which helps to analyze the operational efficiency and performance
of the company when compared to the previous year results. Current Ratio:
The current ratio is a measure of the firms short term solvency. It
indicates the availability of current assets in rupees for every one rupee of
current liability. A ratio of greater than one means that the firm has more
current asset than claims against them.
(Rs. In 000s)
Interpretation:
The companys liquidity position in the year 2009 was 1.024:1 which
indicates the current asset are ahead of current liabilities but still when
compared to the standard (2:1) it need to be improved. The solvency ratio
in the year 2010 was 1:1 which indicates the Current assets were equal to
current liability which is not a good sign at the time of contingency. The
company had a down fall in the year 2010 and gradually started improving
in the year 2011 with the ratio of 1.026:1 and with the growth of 2.6%.
Net Profit:
Net profit helps in measuring the efficiency in manufacturing,
administration and selling of the product.
Year Current Asset Current Liability Current
Ratio
% of Growth
2009 1149184 1121223 1.024:1
2010 1930392 1925910 1.00:1 - 2.34%
2011 1937966 1888216 1.026:1 2.6%
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Interpretation:
The net profit of the company has been decreasing for past three
years. This is because of the company has spent more on their promotional
activities. But actually the company is improving because the percentage of
loss when compared to the previous year has decreased i.e. nearly 25% of
decrease in the loss is really a good sign of improvement for the company.
Return on Equity:
The return on equity helps to analyze the profitability of the investment
made. This can be calculated by using PAT and Net worth.
Interpretation:
Here, the return on equity for the year 2009 was low. Later, it has
started improving. The growth percentage of the return on equity has
increased from 4% to 25% which is a vast increase and coming years it
would be profitable for long term investors.
Year Net Profit % of Growth
2009 (1357640)
2010 (2407096) - 77.3%
2011 (3624932) -50.59%
Year PAT NW ROE % of
Growth
2009 (1102337) 4486272 -0.245
2010 (1049456) 4493046 -0.233 4.89%
2011 (1217836) 6979930 -0.174 25.32%
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Earnings per Share:
EPS shows the profitability of the company on per share basis.
Interpretation:
The EPS of the company in 2009 is very low but gradually has started
improving in the year 2010.The growth percentage has been in the
increasing pace in 2011 when compared to the previous year. The company
is gradually improving to a better form.
Return on Investment:
The term investment refers to net assets or total assets. The funds
employed in net assets are known as Capital Employed.
Interpretation:
The return on investment of the company is not much profitable but its
improving gradually and it would benefit only for long term investors. This is
due to the investment made in promotional activities.
Year EPS % of Growth
2009 (4.99)
2010 (2.33) -53.30%
2011 (2.53) -8.5%
Year EBT NA ROI % of Growth
2009 (102328) 189745+
1149184
-0.0764
2010 (1049450) 172126+193039
2
-0.499 -553%
2011 (1217836) 170347+193796
6
-0.577 -15.63%
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