A review of asset liability management models

Dilawar Ahmad Bhat

PhD Student, Department of Management, Birla Institute of Technology and Science Pilani
Email: adilawars@gmail.com

Abstract
The purpose of this article is to provide a snapshot of the field of Asset Liability Management
(ALM) from a theoretical and modeling perspective. Asset-Liability Management has grown
considerably complex making use of advanced mathematical techniques and computation.
Stochastic programming seems intuitively the best choice out of the available ALM techniques
for strategic asset liability management. This approach helps in multi-period investment
decisions, portfolio rebalancing and accommodating uncertainty by examining few economic
states in the future. This study provides an overview of the evolution of ALM from the idea of
asset-liability matching to sophisticated techniques like stochastic programming. This can help
new researchers and ALM practitioners in banks and other entities to easily understand the
theory and models used in asset liability management.

Keywords: Asset allocation, risk-integration, ALM models, duration, immunization, stochastic

programming
JEL Codes: G00, G11, C6, C61

Introduction
A bank is primarily concerned about the structure and health of its balance sheet in terms of
maturity profile of assets, liabilities, exposure of assets and liabilities to changes in interest rates,
and the impact of macro-economic variables e.g. GDP, inflation, exchange rate etc. Given the
bank’s risk tolerance and other constraints, it tries to formulate, monitor, implement and revise
its strategies related to its structure (assets and liabilities) to attain its financial objectives. The
main aim of ALM is maintaining a structural balance with optimal investment in assets and
temporal equilibrium in the balance sheet with a view to jointly evaluate risks and rewards
associated with assets and liabilities and satisfying current and future goals. The traditional piece
meal approach to management of risks on a stand-alone basis is no longer viewed as a healthy
practice and hence there is a growing inclination towards managing risks in an integrated fashion
(Rosen and Zenios, 2006). Asset-Liability Management addresses the risks arising due to
mismatch in asset liability structure emanating from either difference in liquidity or changes in
interest. In a narrower sense, it has been defined as the process that deals with interest rate risk
management (John Brick, 2012)
“The continuous process of formulating, implementing, monitoring and revising strategies
related to assets and liabilities to achieve an organization's financial objectives, given the
organization's risk tolerances and other constraints” (Abbott et al., 2003).
A financial institution faces different types of risks such as credit, liquidity, market and
operational risk. Modern risk management follows an integrated risk management approach for
managing enterprise-wide risks assuming that different risks like interest rate risk, market risk,
and liquidity risk are all interrelated (Rajan and Nallari, 2004). From an ALM perspective, some
of these risks may originate endogenously (e.g. operational risk) while others might arise from
the exogenous environment (e.g. market risk) while still others might arise from the interplay of
exogenous and endogenous factors (e.g. liquidity risk). ALM is a banking response to the
external and internal risks so that their collective impact on the bank is minimized. Although
management of short-term risks, requiring tactical risk management, is important for effective
implementation of ALM, yet ALM generally has a long-term orientation making it a strategic
discipline (Choudhry, 2007).
ALM helps to determine a long-term configuration of assets for repaying liabilities in future,
whether as a single cash outflow or a series of cash outflows over multiple periods. ALM has
several benefits: representation of a company's overall picture in terms of its liabilities; the
quantification of risks and risk preferences; better preparation and handling of future
uncertainties; and, increased efficiency and better overall performance.
Despite the widely accepted benefits of ALM, implementing an ALM framework is a rather
daunting task because objectives of each institution are unique and differ from others in terms of
constraints, risk tolerances and other contextual factors making it difficult to develop a robust
ALM model which integrates various individual components like policy constraints, institutional
goals, assets, liabilities etc. in a meaningful way. Second, quantifying changing risk preferences
in a mathematical language is far from trivial. Third, it is not easy to develop an optimization
algorithm for making asset allocation decisions by realistically considering all bank-specific
factors. Finally, it is not easy to develop forecasts for long-term strategic decisions because they
are influenced by factors which are highly dynamic in nature may not be readily available to the
bank.
Financial institutions generally analyze risk from an event-driven perspective and Global
Derivatives Study Group (1993) categorizes the following risks as the event-driven risks:

a) Market risk: Risk that is generated from market forces like changes in asset-prices,
exchange rate, Interest rates, derivative contracts etc. Such risk factors are dependent on
collective market rates or indices.
b) Liquidity risk: Risk that stems from a mismatch between cash inflows and cash outflows
at the current or some future point of time. Liquidity risk is of two types: market liquidity
risk and funding liquidity risk.
 Funding liquidity is related to lack of access to funds and captures a bank’s inability to
raise required funds to meet anticipated and unanticipated current and future liabilities
without affecting its daily operations or future financial health (Rosen and Zenios, 2006)
While as market liquidity risk or trading liquidity risk arises when a bank finds it difficult
to offset a position or establish a new position at the prevailing market price due to
market disruption or inadequate market depth”.

c) Credit risk: Risk of loss that arises due to the potential non-payment of obligations by an
obligor. Credit risk can be direct or indirect. Downgrade risk (perceived default in the
future) and default risk (actual failure to pay or honour obligations which have become
due) are direct credit risks. Indirect credit risk arises when a third party’s credit quality
changes unfavorably. For example, when a country’s credit quality gets downgraded, this
results into a change term structure of interest rates which ultimately affects the financial
contract values

Objectives of the study

The objective of this study is to present a concise overview of Asset-Liability Management
theories and models and present a classification of ALM models. Such an overview can be
helpful for the novice researchers in the field of ALM for acquiring a broad understanding of
ALM and its current status. We do not wish to make this a comprehensive literature survey. Our
purpose is to provide a starting point for new researchers and practioners who want to carry out
further research in the field of ALM.

Methodology of Literature Review

We have used the following three keywords “Asset allocation”, “ALM models” and “Theories of
Asset Liability Management” for searching the prominent databases like SCOPUS, Web of
Science, Emerald Insight, Taylor and Francis, EconPapers, Wiley Online Library, Google
Scholar and Google Books. Initially we got 123 articles including three books. After removing
the duplicates across different databases, we were left with 70 articles. Out of the 70 articles we
found 55 articles and three books were highly related to our topic. Wherever the direct access
through the above-mentioned databases was not available we used other options like
ResearchGate etc. to get access to the required papers from the authors.

Theory of Asset Allocation and Risk

Investing funds in different asset classes lies at the core of risk diversification philosophy. Not
putting all eggs in one basket is the proverbial saying which embodies the wisdom of risk
diversification. By allocating assets to a mix of investments classes, investors diversify their
investments and minimize the downside risk. Asset allocation makes intuitive sense because
when the price of one asset class goes down, other assets may perform better thereby reducing
the likelihood of loss.
Markowitz mean-variance efficiency- Beginning of Portfolio Asset Allocation
Markowitz (1952,1959) and Roy (1952) laid the foundations of modern portfolio theory (MPT).
This theory propounded that risk and return go hand in hand. The basic assumption underlying
MPT is that investors avoid taking risk (risk-averse) i.e. they choose a low risky portfolio of
assets over a high-risk portfolio for a given return. Thus, an investor will assume more risk only
she is expecting a higher return for the excessive risk. Assuming risk as inherent part of the
higher return, the construction of return optimized portfolios by risk-averse investors for a given
risk level is explained by MPT theory. For a given level of risk, it is possible to find an “efficient
frontier” of optimal portfolios yielding the maximum possible expected return for a given risk
level and vice-versa.
“The efficient frontier is a parabola in the mean/variance space and a hyperbola in the
mean/standard deviation space” (Merton, 1972).
An asset is defined as an investment (e.g. a stock, currency, option, bond or portfolio) that can be
traded i.e. it can be bought and sold. (Luenberger, 1998). Suppose an investor purchases an asset
at time zero and sells it after some fixed time, T. Let us assume a single period horizon and a
market without taxes and transaction costs.
Let M0 is the money invested by the investor at time 0, and let M t is the money she receives after
the sale of this investment at T. Then the total return, R, on Investor’s investment is defined as
MT
R= (1)
M0

The rate of return, r is given by

M T −M 0
r= (2)
M0

Which gives R = 1 + r
If the investor wants to invest her money into n different assets, she forms a portfolio. Each asset
in a portfolio has a total return given by Ri; i = 1, 2,…..n. Let us suppose that the investor invests
n
an amount M0i in asset i such that ∑ M 0 i=M 0 . Assuming wi [ i = 1,2,…,n] as the weight of
i=1
n
investment in asset i, we have M 0 i=w i M 0 with ∑ wi=1. The total return, R of the portfolio is:
i=1

n n

∑ Ri wi M 0 ∑ (1+ r )i w i M 0 n n
(3)
i=1
= i=1 =∑ w i+ ¿ ∑ r i wi ¿
M0 M0 i=1 i=1

n
Or, r =∑ w i r i [Since, R = 1 + r]
i=1
The return the investment earns is not certain and hence, r is a random variable. In this case,
expected return and variance is given by:
n
E [ r ] =∑ wi E ( r i ) (4)
i=1

n
2
σ = ∑ wi w j σ ij (5)
i , j=1

Where E[ri] is the mean return of asset i ; E[r] is the average portfolio return and σi j is the
covariance between asset i and j
The basic decision facing an investor according to Markowitz model can be expressed as:

n
Maximize (Return) ∑ wi E(r i) (6)
ij=1

n
Subject to (Variance) ∑ wi w j σ ij=¿ σ 2 ¿
i , j=1

n
(Total weight) ∑ wi=1
i=1

Or
n
Minimize (Variance) ∑ wi w j σ ij (7)
i , j=1

n
Subject to (Return) ∑ wi E(r i)=E (r )
ij=1
n
(Total weight) ∑ wi=1
i=1

It is possible to aggregate risk and return function into one objective function based on their
relative weightage as:
2
σ
Maximize f ( w )=eE [ r ] − ,e ∈ [0, ∞) (8)
2
n
Subject to ∑ wi=1
i=1

0 ≥ wi ≤1
c → 0 means that the investor is primarily concerned about minimizing risk and c→1 means she
does not differentiate between between one basis-point increase in returns and one basis point
squared decrease in variance.

Markowitz doesn’t suggest how an individual investor should choose a portfolio from the
portfolios along the efficient frontier(Markowitz, 1952). The first suggestion as to which
portfolio an investor should choose is put forth by Roy(1952) who recommends choosing that
portfolio of assets on the efficient frontier which maximizes ( µ p−d w )/σ where dw is a worst
level of portfolio return and µ p is the average portfolio return. Cash as a risk free asset is
included by Tobin (1958) because investors exhibit liquidity preference for keeping this
relatively low return asset. He developed a tangent portfolio by combining cash with risky assets.
A tangent portfolio is a point on the efficient frontier from which a tangent intersects the y-axis
at risk-free rate. Tobin’s work was later extended by Sharpe, (1964) and Lintner (1965) by
introducing the assumption that an investor can obtain investable funds by borrowing at risk-free
rate of interest and build efficient portfolios with either negative or positive cash holdings.

Mean-variance asset allocation efficiency is based on the premise that asset returns are mutually
correlated and uses these correlations to minimize the overall portfolio variance. This was a key
insight of Markowitz (Rubinstein, 2002). Markowitz stressed the idea of evaluating securities
with respect to the portfolio to evaluate them based on the diversification benefit they bring to
the overall portfolio. But correlations among assets vary with market characteristics. In bear
markets, asset correlations are stronger (and hence weaker diversification benefits) in
comparison to bull markets. This varying correlation across markets needs to be considered for
developing an efficient asset allocation framework (Ang and Bekaert, 2002)

Expected utility theory

The main drawback of MV approach is that it ignores the investor risk appetite. This problem is
overcome by Expected utility theory. Von Neumann and Morgenstern (1944) formally developed
the expected utility theory in the economic context. EUT helps in decision making under
uncertainty. The main argument of EUT is that for a typical rational risk-averse individual
‘something is better than nothing’ and consumption (of wealth) never results into satiation but
marginal utility does decrease:
U(C) > 0, U1(C) > 0, and U2(C) < 0 for all C,
Where
W: is the wealth which gives opportunities for consumption to an Individual,
U(C): the utility derived from wealth, and
U1 and U2: the first and the second partial derivatives with respect to C.
EUT may not hold true in every case. Certain individuals may love taking risks (e.g. a gambler)
and have convex utility function while as certain others may be risk neutral having a straight line
utility function.
Wealth variable, C, being random in nature so it is not easy to deal with U(C) directly. Therefore
E[U(C)], the expected utility of wealth naturally becomes the viable alternative function of
interest. Taking expectations and using Taylor expansion for U[E(C)], we get:
2 3
1 1
E [ U ( C ) ]=U [ E ( C ) ] + U 2 E [ C−E ( C ) ] + U 3 E [ C−E ( C ) ] +… … (9)
2 3!

As can be seen above, the distribution of C involves higher order moments besides first two
moments i.e. mean and variance. Computation of higher order moments is difficult. Therefore,
normal distribution (defined by mean and variance) is assumed for modelling asset returns(Culp,
2001).

The following quadratic utility function can also be used as an alternative way to remove higher
order moments:
a
U (C )=C− C 2
2
where, U3 = U4 = 0, leaving only first two terms, E(C) and E(C) 2 in equation (9). This utility
function for risk preference approximates an investor’s single period optimal portfolio selection
decision based on mean and variance only (Markowitz, 1959).
These two fundamental theories have inspired the development of various asset-liability
management models which have been shown below in figure 1 and discussed in the following
section.

Asset-liability management models

Based upon the time horizon over which the asset-liability optimization decision is to be
modeled and the conditions under which it is to be modeled, we can categorize the ALM models
into four basic categories(Rosen and Zenios, 2006) : (1) Single-period static models (2) Single-
period stochastic models (3) Multi-period static models (d) Multi-period stochastic models.
These models have evolved from the works of Mulvey and Viladmirou (1989), Mulvey and
Zeimba (1998), Mulvey (2001) and Kosmidou and Zopounidis (2008). These models represent
an extension of risk measures and ALM goals from single period settings to multi-period
settings.
 ALM
models

Single period Multi-period

Single period Multi-period stochastic
stochastic static models
static models models
models

Scenario/Simulation Stochastic
Dedication Gap Stochastic
Immunization Analysis Optimal
Management Programming
Control
Figure 1 ALM model classification.

Single-period static models

These models are used as a hedge against small changes in interest rate and exchange rate which
have a significant impact on the overall portfolio value. The portfolio behaviour is made
predictable so that the investors find it acceptable. The main strategies under this category are
dedication, immunization and Gap/surplus management.

Dedication
Dedication was the foremost technique of ALM used by investment companies and pension
funds during 1970’s. Leibowitz first used cash flow matching and termed it “dedication” as it
requires dedicating a series of cash outflows (liabilities) to a series of cash inflows (assets).
Dedication model assumed that the bonds were held to maturity. Some of the advantages of this
technique include simple asset allocation, specificity, passive management and risk reduction.
The main challenges faced by this model: difficulty of construction, complicated, projecting
future cash flows.

Immunization
Originally developed by Redington (1952) and subsequently extended by La Grandville (2001,
2007) the main aim of this technique is to hedge a portfolio against interest rate changes.
Immunization minimizes the volatility of surplus (the difference between assets and liabilities)
by matching asset duration with liability duration. The present-value-weighted mean time to
receipt of the cash flows from an asset or portfolio is called duration. In a notable work,
Macaulay first introduced the term duration (Frederick R., Macaulay and R., 1938). In 1945,
Samuelson came up with the same idea, terming it the “weighted average time period”
(Samuelson, 1945). However, it was in (Redington, 1952) that the concept of immunization was
formally developed. Subsequently the concept of immunization along with different strategies
and their applications was further explored in (Fisher and Weil, no date; Leibowitz, no date;
Vanderhoof, 1972; Thompson and Jr., 1981; Fong and Vasicek, 1984; Maloney and Yawitz,
1986; Williams, 1992; Fooladi, Roberts and Mackay Chair, 2000; Waring, 2004; Waring and
Siegel, 2007; Waring and Whitney, 2009)

Gap/surplus management
This technique measures the difference in asset and liability values and aims to keep the
difference within an acceptable band of positive and negative limits. Financial institutions
generally use this method to manage their balance sheets.

The most widely used ALM strategies in the banking industry are immunization, dedication, and
gap management. These strategies have been extended to stochastic and multi-period settings for
developing realistic models. For instance, Zenios (1995) uses Monte Carlo simulations for
adapting static immunization and dedication to stochastic environment. Similar attempts have
been made in (Gajek, 2005; and Monfort, 2008).

Stochastic models with one period horizon

Single period stochastic models capture the impact of random market movements on return
distribution of assets and liabilities over a single investment horizon. The classical mean-
variance model is an example of the single period stochastic model. These models generally use
downward asset movements as measures of risk e.g. absolute deviation, conditional value at risk
and semi-variance.

Multi-period static models

As is evident from the name, these models consider an analytical optimal solution to the mean-
variance formulation in multi-period portfolio selection where investors can change or readjust
their portfolios to maximize expected value utility function of the wealth at the end of investment
period. Typical examples of such models can be seen in Chambers & Charnes (1961) and D. Li
& Ng (2000).

Stochastic models with multiple planning horizons

These models consider assets and liabilities as random variables which evolve with time
following probability distributions. Adjustment of portfolios by investors is assumed based on a
change in the underlying driving factors or appropriateness of previous decisions. The early
adaptation of mean-variance framework to the multi-period setting can be found in (Brodt,
1978). Other extensions include(Gu et al., 2010; Li and Li, 2012; Shen, Zhang and Siu, 2014;
Chang, 2015).

Scenario analysis/simulation
Stochastic ALM models are based on scenario generation. A scenario is a forecasted unique state
realized by randomly changing variables of the model during the planned investment period.
Depending upon the computational power available, the number of scenarios can be large or
small. For taking the decision, each scenario may be weighted, the weights being a function of
existing macro-business environment. A set of scenarios is generated with a view to representing
the universe of all future outcomes as much as possible. Related work on scenario generation can
be found in (Mulvey, 1996, 2001; DeYoung and Yom, 2008).

Stochastic optimal control

Stochastic optimal control, unlike scenario generation, involves Markov process modelling of a
relatively fewer number of variables representing the initial state. This method is used in cases
where a few factors (less than or equal to four generally) represent the state of the world because
as the number of state variables increases, the size of the problem grows exponentially. Since
this approach poses computational problems as the number of variables increases, that is why
this does not find any commercial or practical applications in management. This method has
been used in (Merton, 1969; Samuelson, 1969; Brennan and Schwartz, 1998).

Stochastic programming (SP)

Mathematical problems (e.g. linear programs) in which the data of some variables in the
objective function is uncertain and is stochastically characterized using probability distributions.
Stochastic programming, unlike stochastic optimal control, describes uncertainty by discretizing
time. In the ALM context, Grebeck and Rachev(2005)and Tokat(2003), are notable reviews on
the methods of stochastic programming while as (Valladão, Veiga and Veiga, 2014; Liang and
Ma, 2015; Duarte, Valladão and Veiga, 2017) are some recent applications. Stochastic
programming is particularly useful in situations when the organization is trying to achieve
multiple competing goals of differing priorities simultaneously. Examples of such modelling
specifications can be found in Mulvey & Ziemba (1998) and Kosmidou & Zopounidis (2008).
One big advantage of SP over simulation is that it can easily incorporate scenarios with high
impact but low likelihood without requiring creation of a large number of new scenarios
(Claessens and Kreuser, 2007). Furthermore, relatively larger number of random factors driving
the model can be accommodated. However, the downside is that for a multi-variable and multi-
period decision problem computation becomes difficult. Stochastic programming has gained
popularity in portfolio management because it allows modelling a multi-variable/period decision
problem with conflicting objectives and constraints. It also considers reversible investment
decisions and low probability but high impact scenarios.

Concluding remarks
A broad review of asset liability management (ALM) models in this study has shown that the
idea of ALM modelling has its roots in Markowitz Portfolio Theory. The basic idea of the theory
is risk minimization for a given level of return and vice-versa. The matching of assets with
liabilities, which represents the ALM in its simplest form, is also a form of minimizing risk.
From a modelling point of view, ALM has grown considerably complex making use of advanced
mathematical techniques and computation. Stochastic programming seems intuitively the best
choice out of the available ALM techniques for strategic asset liability management. This
approach helps in multi-period investment decisions, portfolio rebalancing and accommodating
uncertainty by examining few economic states in the future. Capturing the major states of future
is essential for portfolio management. Moreover, the tree structure of stochastic programming is
quite helpful in modelling uncertainty.
Future directions
The main idea behind any modelling framework is to devise an objective function as realistically
as possible and then achieve that objective with efficiency. However, the goal setting in an
organization (e.g. a bank, pension fund etc.) is a human phenomenon. Since humans are assumed
to behave rationally, the problem arises when they do not. Asset-liability management models
should take this behavioral aspect into consideration. Thus, ALM modellers should venture into
behavioural finance for more meaningful modelling insights.

Implications of the study

Based on this summary review, we hope that the new researchers and finance practioners would
find this study highly useful for understanding the theoretical basis of ALM as well as the status
of extant ALM modelling approaches.
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