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 have established a maximum goal ratio to avoid liquidity problem.

Tools and Techniques

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 examiners can 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.

Tools and Techniques

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 optimized allocation 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 assigned to 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.

Tools and Techniques

114Days Capital Liab-fixed Int Liab-floating Int Others Total outflow Investments Loans-fixed Int Loans - floating int Others Total Inflow Gap Cumulative Gap Gap Ratio 300 350 50 700 200 50 300 50 600 -100 -100 -14.29

15-29 Days

30 Days-3 Month 200 350

3 Mths 6 Mths

6 Mths 1Year

1Year 3 Years

3 Years -5 Years 200 450

Over 5 Years 200

Total 200 2600 3400 300 6500 2500 600 3100 300 6500 0 0 0

300 400 50 750 150 100 300 50 550 -100 -200 -15.38

600 450

600 500

300 450

200 450 200

550 250 0 400

1050 250 100 650

1100 300 150 500

750 100 50 650

650 350 100 150

1050 900 100 150 200

650 100 -100 18.18

1000 -50 -150 -4.76

950 -150 -300 -13.64

800 50 -250 6.67

600 -50 -300 -7.69

1350 300 0 28.27

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.

Tools and Techniques

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

Tools and Techniques

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 BOND WHEN INTEREST RATE IN 10%
YEAR CASH PAYMENTS(ZERO COUPON BONDS) 100 100 100 100 100 100 100 100 100 100 1000 PRESENT VALUE OF CASH PAYMENTS 90.91 82.64 75.13 68.30 62.09 56.44 51.32 46.65 42.41 38.55 385.54 WEIGHTS (% OF TOTAL PV=PV/RS 1000) 9.091 8.264 7.513 6.830 6.209 5.644 5.132 4.655 4.241 3.855 38.554 WEIGHTED MATURITY 1x4/100 YEARS 0.09091 0.16528 0.22539 0.27320 0.31045 0.33864 0.35924 0.37320 0.38169 0.38550 3.85500

1 2 3 4 5 6 7 8 9 10 10

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 zerocoupon 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 interest rate 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.

Tools and Techniques

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%

Tools and Techniques

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 subscenarios, 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 worstcase 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

Tools and Techniques

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

Tools and Techniques

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:

Tools and Techniques

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 :

X1i is 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.

Tools and Techniques

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,

Ui is funded from the shareholders account G.

On the other hand,

Vi is 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.

Tools and Techniques

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 (*vi) 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 not just 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:

Tools and Techniques

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 are derived 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.

Tools and Techniques

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)

Year

Current Asset

Current Liability

Current Ratio

% of Growth

2009 2010 2011

1149184 1930392 1937966

1121223 1925910 1888216

1.024:1 1.00:1 1.026:1 - 2.34% 2.6%

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.

Tools and Techniques

Year 2009 2010 2011

Net Profit (1357640) (2407096) (3624932)

% of Growth

- 77.3% -50.59%

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.
Year PAT NW ROE % of Growth 2009 2010 2011 (1102337) (1049456) (1217836) 4486272 4493046 6979930

-0.245
-0.233 -0.174 4.89% 25.32%

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.

Tools and Techniques

Earnings per Share: EPS shows the profitability of the company on per share basis.
Year 2009 2010 2011 EPS (4.99) (2.33) (2.53) -53.30% -8.5% % of Growth

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.
Year 2009 EBT (102328) NA 189745+ 1149184 2010 (1049450) 172126+193039 2 2011 (1217836) 170347+193796 6 -0.577 -15.63% -0.499 -553% ROI % of Growth

-0.0764

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.