6.Tools and Techniques

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/Benchmarking


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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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6.Tools and Techniques