Asset Lability Management Final

8/8/2019 Asset Lability Management Final

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ASSET LIABILITY MANAGEMENT


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Risk management tools

Insurance

Hedging

Asset liability management


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Average per firm risk

For insured the payment of premium even if

more than IFE is money well spentShall result in reduced financing cost


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Insurers per firm risk is small

Individual risk of fire are not highly correlated

PFR= IFE/ Underoot of N IFE= Individual firms exposure

(probability of fire X loss resulting from fire)

N = number of firms insured with identical risk


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DEFINATION

Asset liability is a conceptual tool of financialengineering.

Asset and liability management is the practiceof managing risks that arise due tomismatches between the assets and liabilities.

Strategic management tool

To manage interest rate risk

Liquidity risk faced by banks, other financialservices companies and corporations.


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CONT.

As time went on, ALM become progressivelymore aggressive.

in both 1950 & 1960 decade their were total 16

times interest change. In the 1970 decade theirwas 139 times interest change ,as paceaccelerated their was 50 times change inbetween oct.1979 to dec. 1980.

The need of ALM looks more when people startdisintermediation their fund to earn higherreturn else where.


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THE FOUNDATION CONCEPT

There are 5 foundation concept to understand

all asset liability strategies management.

Liquidity Term structure

Interest rate sensitivity

Maturity composition

Default risk


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Pension fund-exposed to considerable interest

rate risk

Policies in various forms Most popular GIC i.e guarantee a fixed

stream of future income to their owners


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Mutual fund- Assets and liabilities

automatically matched

Timing and amount of cash outflows fromassets match with the amount and timing of

the cash flows from liabilities.


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Dedicated portfolio

An asset portfolio constructed to precisely

match cash flows

Extremely difficult if, not impossible Very expensive/ may require to leave more

attractive opportunities

So, what is the solution


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Portfolio immunisation

F.m Redington in 1952.

First of all check interest rate sensitivity using

Duration Developed by Federick Maculay in 1938


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Duration

Relative measure of measurement of interest

rate sensitivity of a debt instrument.

Weighted average of time to instrumentsmaturity

Weights are present value of individual cash

flow divided by PV of the entire stream of cash

flows


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problem

Liability has a present value of $760.61 so

that at each and every point of time in future

the present value of assets is equal to present

value of liabilities.

Two investment oppoutunities

1. 30 years treasury bonds paying a coupon of 12%

selling at par. (D= 8.08 years)

2. 6 month treasury bills yielding 8%( D= .481years)


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Duration concept is not without flaws

Duration value are reliable for only short

periods of time.

Durations and yield changes may not be samefor all the instruments.

A problem with the assumption that all

movements of the yields curve take form of

parrallel shifts.


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Risk says: MAIN HOON NA

Currency matching strategy eliminates a

large part of risk

But in repatriation of profits currency riskstill remains

So within each currency take portfolio

immunization strategy to counter interest rate

risk.

Can use hedging


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TERM STRUCTURE

Liquidity is loosely define as the ease with which asset can beconverted in to cash. their are two dimension to liquidity

Maturity

Marketability.

LIQUIDITY

At any given point there is a relationship between interest

rates on bonds of different maturities. On that basis of maturity debt instrument are divided into money marketinstruments and capital market instruments. Such a relationcan be drawn on two securities having same credit ratingusually depicted in the form of a graph often called a yieldcurve.


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INTEREST RATE SENSITIVITY

There are two ways to look at interest rate sensitivity.

Degree with which an instrument price will changewith change in yield of security.

Degree with which change on interest with change in

market rate.

MATURITY COMPOSITION The maturity of asset and liability is matched or not. if

it is matched then the company has spread like bank

give loan of 8000Rs for three years at 10% andborrowed 6000 Rs for 3 years at 8% and rest borrow for3 months in that case bank has spread lock of 6000Rsand spread of 2%.


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DEFAULT RISK

Default risk is a risk that the debtor will be

unable to pay the loan principle or interest.

financial institution assess the default risk in

depth and charge their interest rate on the

basis of risk.


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CHANGING FACE OF LIQUIDITY

MANAGEMENT

In earlier days one of the major concern was alwaysliquidity. since depositors at financial institutions couldwithdraw at short notice, so they have to maintain highcash in liquid form.

Liquidity management changed dramatically after theintroduction of certificate of deposits like suddenwithdraw will be offset by quick issue of CDs.

Earlier bank keep 50% in cash form then reduce to 45%

then to 30%.

The CD approach soon replicated with the introductionof commercial papers.


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MARGIN MANAGEMENT

1. The essence of modern ALM, in achieving the long termgoal of wealth maximization, is efficient and effectivemanagement of interest margins and spreads. Alsoimportant is the concept of the gap.

The gap may be define as: Difference in floating asset rate and floating liability rate.

Difference in fixed asset rate and fixed liability rate.

The simple strategy is a simple spread strategy in this ALMgroup would look to lock-in spread by matching both the

type.2. More aggressive strategy is gapmanagement. In gap

management the institution varies the gap in response toexpectation about the future.


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PROBLEM IN GAP MANAGEMENT

Spend great time on predicting future rate but

predictions are only predictions.

All the old problems are enumerated with theintroduction offorwardrateagreement.

Swapsandfuture contactand currency

contract.


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THE INVESTMENT BANKER

In an efforts to carve out new product niche, a

number of investment banker develop

strategy to assist financial institutions.

Some strategies succeed, some fail

Two techniques

Total return optimization

Risk control arbitrage


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TOTAL RETURN OPTIMIZATION

Total return optimization employs tools from themanagement sciences, such as linearprogramming, in an efforts to determine the

optimal mix of assets given a set of constraints. Suppose a client having five securities treasury

bills, treasury bonds, state bonds, local municipalbonds and corporate bonds.

What composition we have to maintain tomaximize our return under giving a set of constraints.


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RISK CONTROL ARBITRAGE

Risk controlled arbitrage is an effort to

maximize the interest of spread by purchasing

high-yield assets and funding these assets at

the lowest possible cost.


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ForwardRate Agreement- FRA

An OTC contract between parties that determines therate of interest, or the currency exchange rate, to bepaid or received on an obligation beginning at a futurestart date.

The terms of the contract : will determine the rates to be used

termination date

and notional value.

On this type of agreement, it is only the differential that ispaid on the notional amount of the contract.

Also known as a "future rate agreement".


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Typically, for agreements dealing with interest rates, the parties tothe contract will exchange a fixed rate for a variable one.

The party paying the fixed rate is - borrower,

party - receiving the fixed rate is the lender.

For a basic example, assume Company A enters into an FRA withCompany B in which Company A will receive a fixed rate of 5% forone year on a principal of $1 million in three years. In return,Company B will receive the one-year LIBOR rate, determined inthree years' time, on the principal amount. The agreement will besettled in cash in three years.


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after three years'

LIBOR is at 5.5%,

Company A pay Company B. This is because

the LIBOR is higher than the fixed rate.(Mathematically, $1 million at 5% generates $50,000 of interest forCompany A while $1 million at 5.5% generates $55,000 in interest

for Company B. )

Ignoring present values, the net differencebetween the two amounts is $5,000, which is

paid to Company B.


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ThanksFOR YOUR IMPATIENT LISTENING


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CommercialPaper

An unsecured, short-term debt instrumentissued by a corporation, typicallyfor the financing of accounts

receivable, inventories and meeting short-term liabilities.

Maturities on commercial paper rarely rangeany longer than 270 days.

The debt is usually issued at a discount,reflecting prevailing market interest rates.


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Investopedia explainsCommercialPaperCommercial paper is not usually backed by any form ofcollateral, so only firms with high-quality debt ratings willeasily find buyers without having to offer a substantialdiscount (higher cost) for the debt issue.

A major benefit of commercial paper is that it does notneed to be registered with the Securities and ExchangeCommission (SEC) as long as it matures before nine months(270 days), making it a very cost-effective means of

financing. The proceeds from this type of financing can onlybe used on current assets (inventories) and are not allowedto be used on fixed assets, such as a new plant, without SECinvolvement.


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Certificate OfDeposit- CD

A savings certificate entitling the bearer to receive interest. A CD bears amaturity date, aspecifiedfixed interestrateand canbeissuedinanydenomination. CDs are generally issued by commercial banks and areinsured.

The term of a CD generally ranges from one month to five years.

certificate of deposit is a promissory note issued by a bank. It is a timedeposit that restricts holders from withdrawing funds ondemand. Although it is still possible to withdraw the money, this actionwill often incur a penalty.

For example, let's say that you purchase a $10,000 CD with an interest rateof 5% compounded annually and a term of one year. At year's end, the CD

will have grown to $10,500 ($10,000 * 1.05).

CDs of less than $100,000 are called "small CDs"; CDs for more than$100,000 are called "large CDs" or "jumbo CDs". Almost all large CDs, aswell as some small CDs, are negotiable.

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Asset Lability Management Final