ALM

1

• ALM
• SECOND PART
• DRUGI DEO

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Managing interest rate risk in the ALM process

• Effects of interest rate risk for a Bank
• Changes in interest rates can have adverse
• effects both on a bank's earnings and its
  economic value. This has given rise to two
  separate, but complementary, perspectives for
  assessing a bank's interest rate risk exposure.

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Managing interest rate risk in the ALM process

• Effects of interest rate
  risk
• Earnings perspective
• In the earnings perspective, the focus of
  analysis is the impact of changes in interest
  rates on accrual or reported earnings. This is
  the traditional approach to interest rate risk
  assessment taken by many banks. Variation in
  earnings is an important focal point for interest
  rate risk analysis because reduced earnings or
  outright losses can threaten the financial
  stability of an institution by undermining its
  capital adequacy and by reducing market
  confidence.
•  In this regard, the component of earnings that
  has traditionally received the most attention is
  net interest income (i.e. the difference between
  total interest income and total interest
  expense). This focus reflects both the importance
  of net interest income in banks overall earnings
  and its direct and easily understood link to
  changes in interest rates.

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Managing interest rate risk in the ALM process

• Effects of interest rate risk
• Economic value perspective
• Variation in market interest rates can also
  affect the economic value of a bank's assets,
  liabilities and OBS positions. Thus, the
  sensitivity of a bank's economic value to
  fluctuations in interest rates is a particularly
  important consideration of shareholders,
  management and supervisors alike.
• The economic value of an instrument represents
  an assessment of the present value of its
  expected net cash flows, discounted to reflect
  market rates. By extension, the economic value of
  a bank can be viewed as the present value of
  bank's expected net cash flows, defined as the
  expected cash flows on assets minus the expected
  cash flows on liabilities plus the expected net
  cash flows on OBS positions. In this sense, the
  economic value perspective reflects one view of
  the sensitivity of the net worth of the bank to
  fluctuations in interest rates.

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Managing interest rate risk in the ALM process

• Since the economic value perspective considers
  the potential impact of interest rate changes on
  the present value of all future cash flows, it
  provides a more comprehensive view of the
  potential long-term effects of changes in
  interest rates than is offered by the earnings
  perspective.
• This comprehensive view is important since
  changes in near-term earnings the typical focus
  of the earnings perspective - may not provide an
  accurate indication of the impact of interest
  rate movements on the bank's overall positions.

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Interest rate gap analysis

• This method is widely used. It consists in taking
  the present balance sheet situation and
  projecting two factors in the future
• The capital flows received or paid out
• The interest receive or paid out
• A Gap is defined as a mismatch between rate
  sensitive assets and rate sensitive liabilities
• The diagram of the differences for the different
  maturities is called the interest rate gap.
• Products are pooled into categories that are as
  homogeneous as possible, with dates that are as
  detailed as necessary.

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Interest rate gap analysis

• There are two types of gaps
• The fixed interest rate gap for a given period
  the difference between fixed rate assets and
  fixed rate liabilites.
• The variable interest rate gap the difference
  between interest rate sensitive assets and
  interest rate sensitive liabilities.

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Interest rate gap analysis

• There are as many variable interest rate gaps as
  there are variable rates.
• Example
• 1 month GAP
• 3 months GAP
• 6 months GAP
• 12 months GAP

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Interest rate gap analysis

• The analysis then seeks to update future
  financing or investment requirements.
• A positive gap for a specific bucket means that
  there are more asstes repricing than liabilities.
  A negative gap for a specific bucket implies that
  more liabilities are repricing than assets.

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Interest rate gap analysis

• Preparing the gap report
• Time Buckets
• Determine the number
• Determine the length of the buckets
• Placing all the products in the report

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Impact on net interest income as a function of
the gap and the evolution of interest rates.
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Interest rate gap analysis

• The former focuses on the impact of changing
  interest rates on reported net interest income.
• The gaps summarize the balance sheet image and
  provide a simple technique to derive possible
  variations of interest income.
• For gap risk, the target variable is the interest
  income

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Interest rate gap analysis

• Gap Limits Gap (maturity or repricing) limits
  are designed to reduce the potential exposure to
  a banks earnings or capital from changes in
  interest rates. The limits control the volume or
  amount of repricing imbalances in a given time
  period.
• These limits often are expressed by the ratio of
  rate-sensitive assets (RSA) to rate-sensitive
  liabilities (RSL) in a given time period. A ratio
  greater than one suggests that the bank is
  asset-sensitive and has more assets than
  liabilities subject to repricing.
• All other factors being constant, the earnings of
  such a bank generally will be reduced by falling
  interest rates. An RSA/RSL ratio less than one
  means that the bank is liability-sensitive and
  that its earnings may be reduced by rising
  interest rates. Other gap limits that banks use
  to control exposure include gap-to-assets ratios,
  gap-to-equity ratios, and dollar limits on the
  net gap.

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Interest rate gap analysis

• Gap Limits
• Although gap ratios may be a useful way to limit
  the volume of a banks repricing exposures,by
  themselves, they are not an adequate or effective
  method of communicating the banks risk profile
  to senior management or the board. Gap limits are
  not estimates of the earnings (net interest
  income) that the bank has at risk.
• A bank that relies solely on gap measures to
  control its interest rate exposure should explain
  to its senior management and board the level of
  earnings and capital at risk that are implied by
  its gap exposures (imbalances).

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Interest rate gap analysis Amortizing
structure of fixed rate Assets Liabilities

• This technique will be shown and discussed during
  the lessons.

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Limitations of interest rate gaps

• Gaps are a simple and an intuitive tool, but have
  several limitations.
• The main difficulties are
• Emphasis on the near term
• There may be mismatches within each bucket which
  become visible as time goes through their impact
  on near term buckets.
• For example a 187 day asset is in the 7-12 month
  bucket now but it will revert to the 3-6 month
  bucket after a week. This may cause a mismatch,
  in both buckets. Even though the position of the
  bank remains the same, two large mismatches may
  be reported in the gap report

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Limitations of interest rate gaps

• As book values are considered, they are
  inappropriate for managing the economic value of
  the bank.
• It is dangerous to rely only on gap reports
  other techniques need to be used in conjunction
  with gap reports.

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Methods for hedging interest rate gaps.

• Interest rate swaps
• Forward rate agreements
• Short term futures
• Long term futures
• Options ( Caps, floors, swaptions)

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ALM Methods

• There is no economic or financial theory of
  asset liability management.
• ALM can be likened to a box of tools used by
  practitioners.
• In this presentation, managing AssetLiabilities
  will be examined
• Duration analysis and BPV analysis

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Duration analysis

• Duration analysis aims to identify the impact of
  a change in market conditions-chiefly, the term
  structure of interest rates-on several items on
  the balance sheet or the profitloss account.

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Duration analysis

• The duration analysis is focussing on the
  economic perspective (market value) which looks
  at the impact of changing interest rates on the
  market value of a portfolio.
• In other words, the focus is on the risk to the
  net worth of the bank that arises from the banks
  interest-sensitive positions.

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Duration analysis

• Interest rate risk is measured in terms of
  sensitivity of a target variable to interest rate
  changes.
• The starting point for a measurement of interest
  rate risk is to determine the market value of
  equity.

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Duration of equity
Duration analysis

• Duration of equity is often used as a management
  tool.
• For example, to prevent market value from
  fluctuating by more than 10 after a 100 basis
  point move in interest rates, risk managers will
  focus on maintaining a duration of equity of less
  than 10 years as proxy for market value.

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Duration of equity
Duration analysis

• But banks must also account for earnings risk.
• The target duration of equity can be determined
  by testing the effects of various investment
  structures that satisfy market value limits on
  net interest income.

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Duration of equity
Duration analysis

• ALM Managers will often have a range of values
  for duration of equity to satisfy the limits they
  have established for earnings and market value
  volatility.
• This allows ALM mangers to operate within a
  closely defined range, and lenghten or shorten
  the duration of equity according to the banks
  market expectations via ALM swaps.

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Duration of equity
Duration analysis

• Duration of equity
• (MV AssetsD assets)-(MV LiabilitiesD
  Liabilities)
• (MV Assets MV Liabilities)

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Duration of equity case study
Duration analysis

• Let us do a simple case study to illustrate the
  application of duration concepts to hedge the
  interest rate risk of an entire balance sheet.

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Duration of equity case study
Duration analysis

• ABC bank has a portfolio of assets of a MV EUR
  100 with a duration of 3, a portfolio of
  liabilities of a MV EUR 90 with a duration of 1,
  and a capital with a MV of 10 EUR.
• Assume initial interest rates are 10.
• Let us measure the interest sensitivity of the
  Bank. How much interest rate risk does the Bank
  have?

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Duration of equity case study
Duration analysis

• Balance sheet Assets MV Liabilities MV
• a portfolio of a portfolio of
• assets 100 borrowings 90
• equity 10
• 100 100

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Duration of equity case study
Duration analysis

• Using the formula, the duration of equity is
  computed as 21, and the modified duration of
  equity is 19.
• For a one percentage change in interest rates,
  the value of equity will change by 19.
• This is a measure of the interest rate risk of
  the bank.

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Duration of equity case study
Duration analysis
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Duration of equity case study
Duration analysis

• Asset duration 3
• modified duration 3/(1.1)2.7The value of
  the asset changes by 2.7 for 1 change in
  interest rates. The new value is 102.7 when rates
  are 9 and 97.3 when rates are 11.

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Duration of equity case study
Duration analysis

• Liabilty duration 1
• Modified duration 1/(1.10) 0.9The value
  of the liability changes by 0.9 for 1 change in
  rates. The liability value changes by
  0.9900.8.
• The new values are 90.8 for 9 and 89.2 for
  11.

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Duration of equity case study
Duration analysis

• Equity
• In each case, it is the difference between
  the value of the asset and the liability. It
  can be seen the value of equity fell by 19 (
  moving from 10 to 8.1) when rates went up by 1,
  and increased by 19 ( moving from 10 to 11.9)
  when rates fell by 1.

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Managing market value risk
Duration analysis

• Once market risk has been estimated, the next
  step is to decide whether to hedge interest rate
  exposures, and then how to hedge them if a bank
  decides to do so.

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Managing market value risk
Duration analysis

• How to hedge the interest rate risk of the
  balance sheet
• the first step is to specify how much risk the
  management wants to have.
• Second, one has to decide on the type of hedge to
  be used.

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Managing market value risk
Duration analysis

• Let us assume that the bank settles on the use of
  an interest rate swap to accomplish the hedging
  objective.
• The swaps duration is computed to be 3,67.
• In order to find the notional amount of the swap,
  one has to revert to the duration formula for the
  duration of equity
• lets assume that the amount of the swap is X

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Managing market value risk
Duration analysis

• If X is the amount of the swap than
• 1003-901-3,67X 0100-90
• solving for the value of X 210-3,67 X 0
• X 57,2

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Managing market value risk
Duration analysis

• Let us verify that with the use of a nominal with
  57,2 of an interest rate swap, the balance sheet
  is immunized. (objective preserve market value)
• Duration of swap 3,67
• Modified duration of swap 3,67/1,13,3
• The value of the swap changes by 3,3 for a 1
  point change in rates.
• If rates move to 11 the value of the swap is
  1,9
• If the rates move to 9 the value of the swap
  is -1,9

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Managing market value risk
Duration analysis
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Managing market value risk
Duration analysis

• A banks choice of target variable often dictates
  the risk management strategy it adopts. For
  example, if a firm with a 20-year asset funded by
  a five-year liability focused on changes in net
  income over five years, its interest rate
  sensitivity over those years will be flat.
• However, if it focused on market value its
  interest rate sensitivity will not be flat.
  Market value will fall sharply as interest rates
  rise, because the assets value will fall while
  the cost of funds rises.

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Managing market value risk with duration
Duration analysis

• The attraction of duration as a measure of
  interest rate risk is that it reflects the
  greater price sensitivity of longer term
  instruments to changes in interest rate risk.
• It provides a single measure of a banks position
  at a particular moment in time that is related to
  the effects of interest rate changes.

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Managing market value risk with duration
Duration analysis

• A bank with a matched duration, or zero gap,
  between asset and liabilities will in principle
  not experience a change in the market value of
  its asset liability portfolio following an
  interest rate change.