1

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
ASSET LIABILITY MANAGEMENT
Significance and Basic Methods
Dr Philip Symes
2

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
Introduction

Asset liability management (ALM) is the management of financial assets by

a company to make returns.

ALM is necessary to maximise return on capital and deal with competition

and risks

A bankers job is to strike the right balance of risk and returns

Need to watch out for regulatory constraints

Liuidity
!afety
"rofitability
#ompetiti$eness
3

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
Contents

%he role of banks

&isk management for ALM

'nterest rate methods

"rice sensiti$ities

(ap management

)se of swaps* caps and floors in ALM

4

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
Role of Banks

+ank,s own capital pro$ides the liuidity cushion between deposits and
loans

-isintermediation. withdrawal of funds from banks to in$est directly

Funds
saved by
those
who have
a surplus
Funds
borrowed
by those
who have
a deficit
Banks
A L
E
Direct

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
Return on Equit E!a"#le

%his example shows how banks generate a return on an

euity
'nterest rates
(ross margin
/ lending rate
/ borrowing rate
0perating cost
Net margin
net income1re$enue
Asset utilisation
re$enue1assets
&eturn on assets
net income1assets
2inancial Le$erage
assets1euity
Return on equit
net income1euity
!

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
Return on Equit E!a"#le
!imple example.

#urrent L'+0& 3 456

%7 cost 3 45.896

+ank borrows at 47.9 bps abo$e

L'+0&

+ank lends at 44.:56

(eneral expenses 3 95bps

"1 # $%
"2 # %
L # &&%
A
&e$enue and expenses.

Assets 3 455;

%ime period 3 4 yr.

&e$enue 3 income from

lending
3 455 < (44.:56)
3 44.:5

=xpenses 3 cost of %7 > cost

of borrowing
3 9 < (45.96) > ?? <
(456
>5.4796)
3 5.979 > ?.@4
3 @.:A9

(ross profit 3 44.:5 / .:A9

3 $%&'(
$

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
Return on Equit E!a"#le

Net profit 3
(ross profit / general
expenses
3 4.@B9 / 5.9
3 4.:B9

Net margin 3
Net profit 1 &e$enue
3 4.:B9 1 44.:
3 5.47?9

Asset utilisation 3
re$enue 1 assets
3 44 1 455
3 5.44

&eturn on assets 3
Net margin < Asset utilisation
3 5.47?9 < 5.44
3 5.54:4:

Le$erage 3
Assets 1 %4 capital
3 455 1 8
3 4:.7?B

&eturn on euity 3
&eturn on assets < Le$erage
3 5.54:4: < 4:.7?B
3 5.754@9
3 )*%) +
&

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
Risk Manage"ent

More details on risk types can be found in the

Introduction to Risk presentation

%he diagram shows the different types of risk in ALM

&isk management
Liuidity
2unding1
Le$erage
'nterest rate
sensiti$ity
#ommercial
strategy
#ompetition
&egulatory
reuirements
'

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
Risk Manage"ent

An effecti$e organisational structure is essential for risk

management
%reasury C #apital market
(roup %reasury
%reasury Markets
%erm
2unding
Liuidity !hort1
Medium
%erm
'nterest
&ate &isk
Long
%erm
'nterest
&ate &isk
(roup
!er$ices1
'n$estor
&elations
#orporate
Marketing
#apital
markets1
-eri$ati$es
Money
Markets
&isk
&eporting
&isk
Allocation
1(

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
Interest Rates

%here are different ways of calculating interest.

!imple interest

#ompound interest

-aycount con$entions (A#%* etc.) can also be confusing

!pot rates (Dero coupon rates)

)sed to calculate the time $alue of money

Eields

)sed for expressing the internal rate of return for fixed

interest coupon bonds or loans

)sed to produce yield cur$es

2orward rates

Market,s expectation of loan rates in the future

11

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
Interest Rates

&elationship between the different rates is shown.

+ootstrapping is used to determine spot rates from

yields.
&ate
2orward
!pot
Eield
2orward !pot Eield
2orward
!pot
Eield
Maturity
12

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
Interest Rates

%he process of bootstrapping is explained in the Eield

#ur$es presentation.

A simple recipe for performing bootstrapping in a

spreadsheet is.
4) #alculate the one year spot rate;
7) #alculate the one year discount factor;
A) #alculate the running sum of discount factors*
starting with year 4;
:) Multiply the running sum of discount factors by the
yield of year 7;
9) %wo year !pot rate is eual to (4 > two year yield)
di$ided by the product of step (:);
B) &epeat steps (A/9) for each successi$e year.
13

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
Interest Rates

=ui$alence principle is used to deri$e forward rates

from spot rates.

%his principal states that a fixed rate loan made from

today for a period of x years must earn the same
interest as a loan made for y years (where y F x) and
rolled o$er for the remaining x / y years

%his method can be simplified using discount factors

(4 > !
7
)
7
(4 > !
4
) (4 >
4
2
4
)
&oute A
&oute +
According to =ui$alence.
2uture $alue $ia route A 3 2uture
$alue $ia route +
or
(4 > !7)7 3 (4 > !4) < (4 > 424)
or 424 3 -24 1 -27 / 4
3 4.5B5A / 4
3 B.5A6
14

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
,rice Sensiti-ities

%he price of fixed income securities is sensiti$e to its

yield (i.e. interest rates)

%he price/yield cur$e of most securities is con$ex.

"rice
Eield #oupon rate
"ar $alue
Ghen Eield 3 #oupon rate
"rice 3 "ar $alue
Ghen Eield F #oupon rate
"rice H "ar $alue
Ghen Eield H #oupon rate
"rice F "ar $alue
1

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
,rice Sensiti-ities

2inancial professionals need a uick measure for price

sensiti$ity rather than using the price euation

Price Value of a Basis Point is the simplest measure of

sensiti$ity and the most widely used
"rice
Eield y
)"
y>4bp
"I+" is the change in price for 4 bp rise in yield
"I+" 3 "rice at 4bp higher yield / "rice at current yield
Ghen Eield 3 8.556 "rice 3 J455
Ghen Eield 3 8.546 "rice 3 J@@.@9@
%herefore "I+" 3 @@.@9@ / 455
3 J/5.5:4

1!

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
,rice Sensiti-ities

Modified Duration is another measure of sensiti$ity

't is better for securities whose price is not eual to par

Modified duration is ratio of the relati$e change in price

to the change in yield for a small yield change (i.e. 4bp)
"rice
Eield y
K"
y>4bp
Ghen Eield 3 8.556 "rice 3 ?8.B@@
Ghen Eield 3 8.546 "rice 3 ?8.BB7
K" 3 (?8.BB7 / ?8.B@@) 3 5.5A?
Ky 3 4bp 3 5.5554
%herefore MD 3 (K" 1 ") 1 Ky
3 (5.5A?1?8.B@@) 1 5.5554
3 :.A
1$

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
,rice Sensiti-ities

Macaulay Duration is widely used in ALM to balance the

a$erage li$es

'.e. the asset and liability sides of the balance sheet

Macaulay duration is the weighted a$erage time to

maturity of the cash flows of security; where the weights
are eual to the present $alues of the cash flows
#lear bar shows the cash flow and the shaded area is its "I
Macaulay duration can be seen graphically as the point in the
life of the security about which the $alue of the present $alues
of the cash flows are perfectly balanced
1&

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
,rice Sensiti-ities

As an example* consider the Macaulay duration of a

?6 fixed rate bond* 9yr duration* yielding 456.

%his can be calculated in a spreadsheet as shown.

+asis. par $alue 3 455 yield 3 456
%ime (yrs) #ash flow "I of cash flow %ime < "I
4 ?.55 8.78 8.78
7 ?.55 B.B4 4A.77
A ?.55 B.54 4?.5A
: ?.55 9.:B 74.?B
9 45?.55 B8.5B AA9.A5
%otal @7.:7 A@9.B?
Macaulay duration :.7?
1'

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
,rice Sensiti-ities

-uration pro$ides a linear estimation of the price

change for a small change in yield

2or large changes in yield it may be necessary to use

con$exity to find the change in price
"rice
Eield
Actual cur$e. K" 3 f (K r)
K " 3 duration < " < K r
K " 3 duration < " < K r > #on$exity < " < K r
7
1 7
2(

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
,rice Sensiti-ities

As an example of con$exity* consider a 9/year* fixed/

coupon :6 bond* yielding 86.

#on$exity is the ratio of the change in duration of the to

the change in yield for a small change in yield (4bp)* so.
Ghen yield 3 8.556 "rice 3 ?8.B@@
Ghen yield 3 8.546 "rice 3 ?8.BB7
Ghen yield 3 B.@@6 "rice 3 ?8.8A8

%hus when yield 3 B.@@ 6* -uration 3 :.7@?B

And when yield 3 8.556* -uration 3 :.A55@

%herefore #on$exity 3 (:.A55@ / :.7@?B) 1 5.5554

3 ).%//
21

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
,rice Sensiti-ities

2ixed rate loans are like bonds and aren,t con$ex.

Loan sensiti$ities can be described by duration.

directly on maturity (duration can,t exceed maturity);

directly on coupon rate;

in$ersely on yield.
-uration
Maturity
-uration of par loans
-uration of Dero coupon loans
22

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
,rice Sensiti-ities

2loating rate loans are effecti$ely fixed rate loans for the
current interest calculation period.

0n the next payment date the $alue of a floating rate loan is

eual to the principal $alue.

-uration is an adeuate measure of the sensiti$ity of a

floating rate note;

-uration of a floating rate note is close to maturity.

2or example* mortgages and consumer loans can ha$e

embedded optionality.

"rice sensiti$ity is based on duration and con$exity;

"repayment risk must be modelled and obser$ed.

23

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
,rice Sensiti-ities

-ifferent yield sensiti$e securities make up a portfolio.

%he change in price of each security for one basis point

mo$e in yields will be depend on its duration;

!o a change in the yield cur$e will securities differently.

Eield cur$es mo$e in the following ways.

856 of the mo$ement in yields can be explained by

parallel mo$es alone;

Another 75/796 can be explained by including

steepening mo$es;

96 is accounted for by cur$ature shifts.

!ee the Yield Curves presentation for more details.

24

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
Ga# Manage"ent

(ap management is the oldest and the most basic

method of managing the balance sheet.

%he (ap is difference between the amount of assets

and liabilities with interest rate sensiti$e cash/flows.

A positi$e (ap exists when the assets exceed liabilities.

+anks want to keep a positi$e (ap when interest rates

are rising* and a negati$e (ap when they are falling.
4755
@55
4795
855
495
'nterest
sensiti$e
assets
'nterest
sensiti$e
liabilities
(ap 3 / 95
=xample.
2

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
Ga# Manage"ent

%he (ap method can be refined using maturity buckets.

Bucket Gap Management.

Maturity buckets are well defined time periods that a

bank monitors on a regular basis.

%he assets and liabilities are separately clumped into

these buckets (these can be fine tuned later).

%he (ap management techniues are then applied.

:55
@55
B55
855
495
'nterest
sensiti$e
assets
'nterest
sensiti$e
liabilities
955
A55
955
495
Negati$e (ap of 755
in 5 / A months
Lero (ap in
A / B months
"ositi$e (ap of 495
in B / 47 months
2!

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
Ga# Manage"ent

%raditional (ap method focuses on the effect of

changes in yield on the income margin.

Duration Gap Management emphasises the effect of

yield changes on the MtM $alue of assets and liabilities

'.e. capital gains and losses.

%he -uration (ap uses the Macaulay -urations of the

assets and liabilities.
2$

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
Ga# Manage"ent

%ake an example of this.

Macaulay duration of assets 3 7.?8

Macaulay duration of liabilities 3 4.89

-uration gap 3 4.47

'mplies that the bank will benefit if interest rates go down.

N+. there are wide duration gaps between asset and

liabilities in different maturity buckets.
0uration
All figures in millions Lloty and are actual market $alues
Assets Ialue -uration Lia1ilities Ialue -uration
#ash 495 5.55 -emand deposits B55 5.5?
!hort term go$ernment securities A55 5.@4 !hort term time deposits 955 5.A9
Long term go$ernment securities A55 8.74 Long term time deposits 955 7.79
Migh uality floating rate loans 955 5.:9 +onds issued 755 A.97
Medium uality floating rate loans :55 5.78 0ther borrowings 495 5.89
2ixed rate loans :55 B.?8 =uity 495 45.55
0ther assets 95 45.55
Total )$** )%23 Total lia1ilities )$** $%3(
2&

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
Ga# Manage"ent

avings ! "oans Crisis in )!A.

!CL offer.

deposit accounts to sa$ers;

mortgages to home buyers.

!imilar to building societies.

-uring the early and mid 4@?5s

about @55 !a$ings and Loans
went bankrupt.

%he total bill for the )!

go$ernment was o$er J955 +N

Ghat went wrongN

?5
B5
A7
?
#ash
-emand
deposits
48
A
2ixed
deposits
!ecurities
Mortgages
=uity
N+. %he assets are
mostly fixed rate with a
duration of 8.5 while a
siDeable portion of
liabilities is floating rate
gi$ing a duration of A.5
A typical !CL.
2'

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
Ga# Manage"ent

%he duration gap became disastrous when interest

rates increased.

-uring late 4@85s and early 4@?5s interest rates were

$olatile and rose by about A6.

%hus the $alue of !CL assets declined by about 756.

K"(assets) 3 - < K y > 417 < #on$ < K y
7
3 /8 < 5.5A > 5.9 < 77 <5.555@ 3 5.75 3 756

+ut the $alue of the liabilities only went up by about ?6

K "(liabilities) 3 - < K y > 417 < #on$ < K y
7
3 /A < 5.5A > 5.9 < 75 <5.555@ 3 5.5? 3 ?6

%hus our !CL suffered a capital loss of 476 which was

more than its euity of ?6 / and went bankrupt.
3(

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
4se of S5a#s6 Ca#s 7 8loors in ALM

A !wap is a contract between two counterparties to

exchange specified streams of cash flows o$er a gi$en
period

=ach exchange of cash flows in the swap can be seen

as a forward contract

A plain $anilla swap is an exchange of a fixed interest

stream for a floating interest stream (e.g. L'+0&)
$%
*
*
*
*
$% $%
$%
!+th L
$%
!+th L !+th L !+th L !+th L
%ime(yr) 2ixed 2loating
5.5 5 5
5.9 "<5.58<Kt /"<Bm L<)t
4.5 "<5.58<)t /"<Bm L<)t
4.9 "<5.58<)t /"<Bm L<)t
7.5 "<5.58<)t /"<Bm L<)t
7.9 "<5.58<)t /"<Bm L<)t
=.g.. 7.9 yr swap where we recei$e 86 and pay Bmth L'+0&.
31

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
4se of S5a#s6 Ca#s 7 8loors in ALM

A bank can use a swap to change the duration of its

assets or liabilities* e.g..
+ank A
:yr +ond
yielding ?6
2ixed
+ank A is long a fixed rate asset with a duration of A.9
+ank A
2ixed
2loating
+ank A goes short a swap with a duration of A.9
+ank A
2loating
As a result* +ank A reduces the duration of its asset to 5.:
32

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
4se of S5a#s6 Ca#s 7 8loors in ALM

A swap can be $alued as a

series of cash flows

%he MtM $alue the sum of the

N"I of all cash flows*
discounted at the swap rate

%he $alue of a swap is the N"I

of the fixed side cash flows*
discounted at the swap rate

'f the MtM $alue is non/Dero*

one of the counterparty is losing
money
=xample.
8 yr swap of notional amount of
455* where we recei$e 45.96
semi/annually and pay Bmth
L'+0& / 95 bps
#urrent 8 year swap rate is @6
"I of floating side 3
/455 > "I of 95 bps o$er 8 yrs
3 /455 > 7.99 3 @8.:9
#oupon of fixed side 3 45.96
Eield of fixed side 3 @6
Maturity 3 8 yrs
"I of fixed side 3 458.B8
N"I of swap 3
/@8.:9 > 458.B8 3 $*%))

33

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
4se of S5a#s6 Ca#s 7 8loors in ALM

#aps and floors are deri$ati$e contracts where the

owner can recei$e the difference between a strike
interest rate and the le$el of an index* e.g. L'+0&

A cap is like a series of options where the owner has a

right to exchange fixed for floating interest payments

A floor is like a series of options where the owner has a

right to exchange floating for fixed interest payments
#ash flow
L'+0&
#ap
L'+0&
2loor
#ash flow
N+. #ap and floor are show from the owner,s perspecti$e
!trike !trike
34

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
4se of S5a#s6 Ca#s 7 8loors in ALM

A bank can limit the interest expense of a floating rate

liability by buying a cap

%he expense of capping a floating rate liability can be

reduced by selling a floor
#ash inflow
L'+0&
#ap
=xpense
L'+0&
2loating &ate Liability
=xpense
L'+0&
O#ollaredP 2loating &ate Liability
!c
!c
#ash outflow
L'+0&
2loor
!f
!f
3

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
4se of S5a#s6 Ca#s 7 8loors in ALM

A long cap and a short floor can make a costless collar.

A swap is a kind of costless collar.

#aps and floors are series of distinct interest rate options.

Ialue of an interest rate option is composed of two parts.

'ntrinsic $alue. the gain from exercising the options

today (depends only on current le$el of interest rates);

%ime $alue. the potential gain due to future

mo$ements in interest rates up to option expiry

depends on $olatility of rates.

Iarious models are a$ailable for modelling interest rate

options.

Analytical models such as +lack/!choles;

Numerical methods. binomial* trinomial*Q

3!

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
4se of S5a#s6 Ca#s 7 8loors in ALM

%here are se$eral reasons for using deri$ati$es in ALM.

Medge. reduction of a part or all of a bank,s exposure;

Arbitrage. exploitation of arbitrage opportunities;

!peculate. creation of new exposures for market

oriented hedging;

"ortfolio management. de/linking maturity and

duration.

'f you belie$e rates will rise (abo$e market expectation) or

that the yield cur$e will steepen* go short on swaps

Iice/$ersa / increase the duration of assets and decrease

duration of liabilities* i.e. go long on swaps
3$

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
4se of S5a#s6 Ca#s 7 8loors in ALM

+ut* if you,re not sure about the rates but want to hedge*
buy an option to switch* e.g..
=
x
p
e
n
s
e
'nterest rate
2loating rate debt
=
x
p
e
n
s
e
'nterest rate
!elling a cap to subsidise the first one
=
x
p
e
n
s
e
'nterest rate
+uying a cap for protection
=
x
p
e
n
s
e
'nterest rate
!elling a floor to subsidise the cap. collar
3&

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
4se of S5a#s6 Ca#s 7 8loors in ALM

Application of a non/generic swap.

A diff swap is a contract to exchange two stream which

are based on indices in two different currencies.

=.g. (+" L'+0& and )!- L'+0&;

N+. %he payments are in the same currency.

%his swap is used to bet on the relati$e steepness of

swap cur$es in the two currencies.
+ank A +ank +
)!- L'+0& >A79bps
(+" L'+0&
3'

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
4se of S5a#s6 Ca#s 7 8loors in ALM

-eri$ati$es can be used to add $alue in se$eral ways.

-eri$ati$es are cheaper than physical transactions.

-eri$ati$es are off balance sheet.

-eri$ati$es can reduce taxes and hence add $alue for

shareholders

hedging debt reduces risk;

the cost of hedging is usually tax deductible;

lower interest rate risk means that the firm can

increase other types of risk.
R
Le$eraged to enhance returns for shareholders.
4(

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
Su""ar

ALM is the management of assets and liabilities in banks

to add $alue to portfolios.

'nterest rates are a major factor in the $alue of many

financial instruments.

"rice sensiti$ity is how much a change in yield changes

the price* and this depends on duration.

(ap analysis is the management of the balance sheet to

simply protect portfolios.

-eri$ati$es can be used to le$erage positions* hedge

risk and add $alue to portfolios.