Report on

“A STUDY ON ASSET LIABILITY MANAGEMENT”

Submitted in partial fulfilment of the requirements for the award of

Post Graduate Diploma in Securities Markets PGDM (SM)

Submitted by:
RAKSHIT RAJ
PGDM(SM) 2021-2023 Batch

Under the guidance of:

Dr. Jatin Trivedi
Associate Professor - School for Securities Education (SSE)

National Institute of Securities Markets

 DECLARATION

I hereby declare that the dissertation proposal titled ‘A STUDY ON ASSET LIABILITY
MANAGEMENT’ submitted to National Institute of Securities Market, is a record of an
original work done under the guidance of Dr. Jatin Trivedi (Associate Professor, SSE
NISM) and this work is done in partial fulfilment of the requirements for the award of the
degree of Post Graduate Diploma in Management (Securities Markets).

RAKSHIT RAJ
PGDM(SM) 2021-23 Batch
30 September 2022
 INTRODUCTION
The technique of controlling the use of assets and cash flows to lessen the firm's
risk of loss from failing to pay a liability on time is known as asset/liability
management. Assets and liabilities that are properly handled boost a company's
earnings. Pension plans and bank loan portfolios are two common examples of
when the asset/liability management approach is used. The economic worth of
equity is also a factor.

Understanding of Asset/Liability Management

Because business managers must make plans for the payment of liabilities, the
asset/liability management approach puts a strong emphasis on the timing of
cash flows. Assets must be available to pay debts as they become due, and the
procedure must guarantee that assets or profits may be turned into cash. On the
balance sheet, there are various asset types that are subject to the asset/liability
management process.

Due to illiquidity or interest rate fluctuations, a corporation may experience a

mismatch between its assets and liabilities. Asset/liability management
decreases the likelihood of this happening.

Taking Defined Benefit Pension Plans into Account

When an employee retires under a defined benefit pension plan, they will
receive a fixed, predetermined pension benefit, and the employer assumes the
risk that the assets invested in the pension plan won't be enough to cover all
benefits. Forecasting the amount of assets needed to cover benefits under a
defined benefit plan is a requirement for businesses.
 Literature Review

Liability Driven Investment (LDI) is the design and implementation of

investment strategies with the goal of ensuring that assets meet liabilities. For a
typical discussion of this subject and for a discussion of LDI's most recent
performance, see Working Party (2007) and Blackrock (2012), respectively. For
insurance and pension plans, LDI is crucial. The writers of Working Party
(2007) concentrate on the practical application of LDI techniques. They
specifically direct the trustees' attention to the fact that, despite the fact that their
opinion is offered and supported by a debate, the problem of selecting an
acceptable discount factor for the valuation of liabilities has not yet been fully
solved. The Working Party (2007) also goes into considerable length about the
division of assets into matching and return-seeking assets. The trustees are still
in charge of selecting a specific strategy, notwithstanding discussions about the
suitability of various asset classes and strategies in light of financial market
factors. What is missing is a strong theoretical underpinning that ensures the
investment strategies satisfy the liabilities in the most affordable manner.

This paper offers a systematic alternative solution to the above problem. It

employs a benchmark based approach, the benchmark approach developed in
Platen (2002) and Platen & Heath (2010). By investing money in both the
benchmark and the savings account, liabilities that pay out at their maturity
dates for units of the savings account are hedged under the benchmark strategy,
as we will show. The hedging is carried out in a way that guarantees that the
obligation is met. The benchmark is used for the hedge of the zero coupon bond
similarly to normal financial planning, but in a strict quantitative manner
providing the maximum rewards. This can be done by applying the benchmark
approach's real-world pricing to the information that is currently available. Such
a mutual scheme is most likely, over the long term, less expensive than systems
that use an external provider, such as an insurance firm or a provider of life
annuities, when sharing the non hedgeable risks and possible benefits in a
pension scheme.
 Object of Study
To model the assets and liabilities of pension fund and then optimize the asset
allocation maximizing the risk adjusted returns and plot the efficient frontier.

Liability driven Investment(LDI) Objective

Contrary to traditional investment strategy where the focus is on risk adjusted
performance whereas LDI focuses on maximising the performance relative to
the liability. This is to ensure high probability of meeting the liability while
maintaining a healthy asset growth.

Scope of Research

BENCHMARK PENSION FUND MODELLING:-

Plan of action
1. Macroeconomic forecasts using time series analysis (EXCEL)
2. Modelling returns of various asset classes like Bonds, equity, Commodity and
wage rates using vector auto regression
3. Predicting state of the economy using logit and probit regression
4. Simulating Macroeconomic scenarios(ESG), State of the economy and Asset
returns using Monte Carlo simulation and cholesky decomposition
5. Curve fitting using cubic polynomials (EXCEL)
6. Modelling asset fund under various asset allocation plans(EXCEL)
7. Mortality tables, Plan contribution and Defined Benefit liabilities(EXCEL)
8. Modelling liabilities for pension fund(EXCEL) and modelling fund assets
and fund liabilities to calculate fund ratio(EXCEL)
9. Liability replicating portfolio, optimum asset allocation using efficient
frontier(EXCEL)
 Methodology
Modelling asset returns:-
 The Asset returns and other factors are modelled linearly consisting of two
sets of predictors
o Own lagged returns ( 1 lag and 2 lag )
st nd

o Economic factors ( current, 1 lag and 2 lag )

st nd

Asset idiosynchratic returns-volatility and correlation

   For simulation we already have the economic factors projections available

to us and lagged asset returns will be known at the point of simulation. This
is the systematic part. 
 The Idiosyncratic component can be generated from correlated normal
random and respective volatilities as we did in ESG. However, there are
two very important observations and adjustments.
Simulate asset returns :-
1. Segregate time series for asset returns and economic factors returns in 2
groups and estimate the volatility and correlation matrices for errors.
2. Predict systematic component
3. Predict idiosynchratic component

Curve fitting :-
 Simulation will generate yield curve for all future times (t) but only for our
chosen liquid maturities i.e. ( 1, 2 ,3, 5, 7, 10, 20, 30 ). 
 We however need to both interpolate missing yield data between 1 to 30
and extrapolate (say 100 years) to be able to project bond asset returns
long-term and The also discount long-term pension benefits 
 The Excel tool gives 2 choices for the curve fitting task (i) Cubic Spline
(Interpolation) + Nelson Siegel (Extrapolation) or 
      (ii) Linear Interpolation + Constant Forward (Extrapolation)

Asset modelling:-
Just like macroeconomic forecasts (economic scenario generation) asset returns
modelling is a two step process:-
Step 1:- Model development i.e fitting model on historical data
Step 2:- Model Application i.e applying the model to simulate future
returns

Table 1.1 Asset classes and their risk profile

Sub-class Return Notes
Asset
Class
Treasury Tenor Zero coupon Assumed Risk free and will
Bond (1,2,3,5,7,10,20,30) yield serve as the base curve
Corporate (Rating) Credit Spread Serves as an investment
Bond AAA-, AA-,A-,BBB- Default rate choice . AA rated bond yield
will be used for Liability
discounting
Public Equity Large Cap, Mid Cap, Dividend
Small Cap, High Div. Yield
Capital
Appreciation
Private Dividend
Equity Index Yield
Capital
Appreciation
Infra Project Dividend
Index Yield
Capital
Appreciation
REITs Equity , Mortgage Cap Rate
Capital
Appreciation
Crude Oil Total Return

Gold Total Return

Commodity Total Return

Index

Table 1.1:-
The above table shows the description of various asset classes and their
risk profiling and about the returns and dividends which various asset
classes can generate hence accordingly the fund invests in the
appropriate asset class.

Modelling economic scenarios

First generate fundamental economic scenarios:-
1.Unemployment
2.Consumption
3.Default rates
4.Investment
5.Credit spread
6.Inflation
7.Interest rates
8.Real GDP Growth rates

Model
F(t)=c + AF(t-1) + e(t)
F(t)-economic variable at t
F(t-1)-economic variable at t-1(1 period lag)
A-beta coefficients (auto +cross terms)
e(t)-error term at

Macroeconomic Model
To some extent, the expansion of the economy is connected to all asset types.
All of the economic factors and, by extension, asset classes, can be connected
using macroeconomic models. They are able to keep the asset circumstances
consistent. There are two different kinds of macroeconomic models that can be
employed to keep the consistency. The first kind is based on an empirical
examination of economic variables. Then, it is presumed that historical
dependencies will still exist in the future. For instance, Cornell (2009) examined
the correlation between U.S. market stock returns and GDP growth from 1947
to 2008. It was determined that the long-term real equity return is likely to be
restricted at 4% to 5% since the long-term real GDP growth rate is unlikely to
significantly surpass 3%. Report from MSCI Barra (2010) also looked into the
connection between GDP expansion and stock return. Using data from
international stock markets, the researchers empirically tested the supply model.
Due to globalisation and the fact that growth comes from new businesses rather
than expansion of existing ones, GDP growth has shown to be a poor predictor
of equity returns. Instead of being a key factor, real GDP growth is seen as a
ceiling on long-term real stock returns. The second kind of macroeconomic
model lays the framework for the economy by taking into account the labour
market, monetary and fiscal policies, as well as economic upheaval. These
simulations take into account variables like the interest rate, GDP expansion,
inflation, and unemployment rate. The dynamic stochastic general theory is one
example.

DSGE models are used by central banks to determine monetary policy.

Sbordone et al. (2010) use a small-scale model to introduce the Federal Reserve
Bank of New York DSGE to the general audience. The model was used to
provide an explanation for the unforeseen rise in inflation during the first half of
2004. Gust and Lopez-Salido (2009) discovered that a restriction on family
financial portfolio rebalancing can explain excess equities gains after a shock to
the economy. By producing countercyclical swings in the equity premium, the
model can assist in explaining how stock prices are sensitive to monetary
policies. Benes et al. (2014) developed a DSGE model to include bank loans in
the economic system and explain the incidence of financial crises.

Case studies:- modelling of macro economic

variables
Data used are the random variables from (0,1) uniform distribution provided
and the data provided by Mr Rolfe’s company prices & cost.
We have used the model constructed by the company based on the information
provided from Mr Rolfe.
GDP Model: Log (GDP index (I,t)) = log (1.03) + log (GDP index (I,t – 1))+
z(I,t) + 0.45 × z(I,t – 1)
Budget strategy: 110 + 0.15 × (GDP index (I,t) – GDP index (I,0)),
Luxury strategy: 52 + 0.55 × (GDP index (I,t) – GDP index (I,0)),
One Side Order Strategy:
Budget Pizza: 50% + 0.13% × (GDP index (i,t) – GDP index (i,0)),
Luxury Pizza: 85% + 0.03% × (GDP index (i,t) – GDP index (i,0)).
GDP Index Simulations from next 10 years.
As we can analyse from the graph that GDP has been increasing and
simulations have been done for 10 years and in the boom period we see that
consumer demand is increasing in these periods and when the GDP is maximum
but the demand slumps when the demand is less during the period when GDP is
minimum hence it is important to simulate demand of both luxury and budget
pizza with the GDP.

Assumptions:-
The following assumptions are made in the model:-
1. The CEO of the company allows for the correlation between pizza sales and
GDP is acceptable for modelling the demand for pizza as a result of GDP
(i.e.pizza sales are related to GDP and the parameters are upto the mark).
2. The estimate of the expenses and selling prices of pizza are accurate and
valid for the ensuing ten years; no inflation adjustments are required.
3. The Business Planning Ltd. time series GDP prediction model correctly
depicts the predicted 10-year distribution of GDP.
4. The alteration to the luxury strategy has no switching cost expenditures.

5. No provision is provided for any investment.

Budget Pizzas Analysis:
The average profit under this strategy stands at Rs 624,629 without side orders
and stdev is 45,838 while the minimum profit is Rs 521,963 and the maximum
profit is Rs 757,123 while the median profit is 620,304 and these are without
side orders but with side orders the average profit rises to Rs 850,250 while the
standard deviation rises to 244666 and minimum profit is Rs.798057 and the
maximum profit is 924384 and the median profit is Rs.847551.

2. Luxury Pizzas Analysis:

The average profit under this strategy stands at Rs 660,124 without side orders
and stdev is Rs315,504 while the minimum profit is Rs 46530 and the
maximum profit is Rs 1572084 while the median profit is Rs 630,354 and these
are without side orders but with side orders the average profit rises to Rs
1184773 while the standard deviation rises to Rs.456726 and minimum profit is
Rs.167696 and the maximum profit is Rs 2512768 and the median profit is
Rs.1142422.
In my opinion derived from the modelling done we can conclude the Fresh
Pizzas should consider selling the Luxury Pizza as the profits are higher in this
strategy but the deviation of profits in this strategy is volatile as well so risk is
also higher. Fresh Pizzas should also consider including the additional side
order in the both the budget and luxury strategy as the profits earned over ten
years calculated using 100 simulations are showing decent results in terms of
profit after considering the various GDP scenarios such as boom, slump in GDP
etc.
To compare the mortgage repayments under variable rate option and fixed rate
option for the bank by projecting variable rates based on random numbers and
then taking 200 simulations and then projecting it for 2 years and then deciding
the final rate for mortgage for the customer for 25 years availing the product
and also evaluating the financial viability of the alternative product which is for
5 years and doing same for this as above.
1. We calculate the expected accumulated deposit at the end of 2
years for both fixed and variable rate option.
2. After this we calculate the amount to be mortgaged by subtracting
accumulated deposit from the average house price.
3. We calculate the monthly mortgage repayment by using PMT
function for 25 years and using rates as modelled under variable
rate and fixed rate for fixed rate option.
4. We calculate the difference between monthly mortgage repayments
under fixed and variable rate option and then we have percentage
 of simulation for which fixed rate option is lower than variable rate
option.
5. We also find key statistics of the differences between fixed and
variable rate option i.e maximum and minimum, average etc.
6. Repeat the above steps for alternative product for 5 years.

Error Terms and Simulation

• The VAR model is a package of multiple parallel regressions. The error
term in each regression does not have to independent.
• As seen from the above matrix, the error terms are not
independent.
• The sole purpose of estimating VAR model parameters is to use these to
simulate future economic scenarios.
• Since the error terms are correlated, we will need to use Cholesky
decomposition to generate correlated random normals for simulation.
We can see from the graph that the average of the differences between fixed and
variable rate option is $14,229.61 and maximum will be $77451.80 and
minimum will be ($38,669) and the number of outcomes in which fixed rate
repayment is lower than variable rate option is 37 (18.50%). We see that the
average of the differences between fixed and variable rate mortgages in
alternative product is $2318.56 and maximum is $8225.74 and the minimum is
$3450.65.
We see that the volatility in differences of fixed and variable in alternative
products is more as compared to the main product hence the main product is
more profitable to bank as the customer also stays for the long time and the
repayments are also stable provided proper risk modelling is done for the
customer before mortgaging the loan.
To analyze profitability of ABC parcel delivery company under various
scenarios considering various risks involved including outside factors which can
adversely affects the number of parcels to be delivered by the drivers in a day
which can ultimately affect the revenue and profits of the company.
1. Colleague’s calculations are correct and have been checked and verified in
the audit trial.
2. The modelling done by the colleague is correct.
3. The number of simulations which are 100 are sufficient enough to
accurately predict the range of scenarios for estimation.
4. Data provided and the methodology used is decent enough.
1. We have used random generation process to take various scenarios for
delivery of parcels and then estimate the profitability.
2. We have also used goal seek and solver to calculate the maximum
amount which can be equally paid to the drivers so that the probability of
hitting the target profitability under all scenarios is 100%.

Modelling asset returns:-

 The Asset returns and other factors are modelled linearly consisting of two
sets of predictors
o Own lagged returns ( 1 lag and 2 lag )
st nd

o Economic factors ( current, 1 lag and 2 lag )

st nd

1 Cholesky decomposition
2 Generate Uncorrelated
Standard Normal Random
Correlation
Matrix (M) =L x LT (8x8)
(8x8) ~N(0,1)
𝜀(8x1)

Lower Upper
triangular triangular

e.g. 3 Generate correlated Standard

Normal Random
10.5 1 0 10.5
0.5 1
= 0.5 0.866 x 0 0.866

𝐿𝜀 (8x1)
 TABLE 1.2 YIELD CURVE ESTIMATION

Bond fund returns

Bond asset class returns need special treatment because:-
1. Ratings can migrate and so yield curve change
2. In case of default recovery amount needs to be calculated which is again
rating dependent

Economic Scenario Generation for Bond Fund Return

With generated scenarios of the Treasury bond yield curve, credit spread and
default rate, the model permits calculation of bond fund income rates and
capital returns, based on bond fund investment strategy. Bond fund income rates
can be used to project the positive cash flows (coupon payments) from bond
investments. These cash flows can be used to meet benefit payout requirements
or be reinvested. Bond fund capital returns are useful to project the bond fund
values. This report uses five bond funds constructed to invest in Treasury bonds
and AAA-, AA-, A- and BBB-rated corporate bonds, respectively.

Shock scenarios
Below are the shock scenarios considered at time t = 0, so as to match the
replicating portfolio value against shocked liability values initially. This is a
more holistic approach in comparison to duration and convexity matching. 
Other shock scenarios can be considered.

Liability – Sensitivity Analysis

 We need to evaluate liability sensitivities to immediate shocks on the
valuation date. This will help us design a ‘Hedging Portfolio’ or ‘Liability
replicating portfolio’
 This liability replicating portfolio is at the extreme left of the spectrum of
LDI model allocation strategies where the goal is to only hedge and not
seek performance. 
 We can check other allocation strategies compared to this liability
replicating portfolio strategy.

Asset – Sensitivity Analysis

Just as we generated Liability sensitie chosen asset allocation strategy at t=0
against the shock scenarios, we do the same.
 TABLE 1.3 YIELD CURVE FITTING
The table shows the yield curve fitting as the thr time passes according to
the term structure given from the forecasted yield curve done on the sheet

TABLE 1.4 SHOCK SCENARIOS OF ASSET CLASSES

We will shock every variable by some basis points and then see the effect and
then simulate it for future estimation to consider the effect of all
macroeconomic variables.
Asset sensitivities

Table 1.5 Asset sensitivities of various economic variables

OPTIMISATION
Funding Simulation

So far we have got 100 simulated scenarios for the following variables each
year for next 90 years
1. Asset values : A (i, t)
2. Liability values : L (i, t)

We also get two very important metrics for optimization

Funding Surplus : FS (i, t) = A(i, t) - L(i, t) 

Funding Ratio : FR (i, t) = A(i, t) / L(i, t)

Classical immunization strategies
Asset and liability changes can be approximated as:-

ΔA=-AD.A. Δy + ½ AC.A.(Δy)^2
ΔL=-LD.L. Δy + ½ LC.L. (Δy)^2

If the hedging ratio is H i.e only H portion of the liability needs to be hedged
then
ΔA=HΔL

Key rate duration matching

Only duration matching works with parallel shifts of the yield curve. An yield
curve ha several tenors which can move by different amounts and which would
require key rate duration matching over the entire yield curve to cover non
parallel movements.

Cashflow matching

All the above measures match the change in PV of asset and liability but
completely ignore actual cashflows(liquidity needs).A more rigorous approach
would be match the actual liability outflows with the asset inflows(values and
timing).
 LIABILITY MODELLING
Liability side:
1) We have to ensure that assets are greater than accrued liability at different
points of time.
2) Accrued liability is PBO i.e present value of liability (benefit payments)
to be paid after retirement as annuity based on work done till today.
3) Accumulated benefit payments (Annuity) = 5 years average salary*
current service period *1% * COLA (Cost of living adjustment).
Note: In accrued liability, we take constant service period (say 15 years).
This payment will happen only if the employee stays in the organization
till vesting period. Also, this payment will happen after the employee has
retired till the date of death.
4) Accrued liability is present value (using risky discount factor survival
probability * DF) of accumulated benefit payments.
5) This accrued liability needs to be calculated at the end of every year (after
each year end). As we move forward in time say at year end 1,2,3 etc.,
PBO will evolve (dynamic PBO) because of two things:
 Current service period – As you move forward in time, say in
yearend 1 , the service length of the employee will increases from
15 years to 16 years. Similarly, if you are calculating PBO at T=2,
we will take service length as 17 years.
 Discounting factor – Discounting factors at each year end will also
be different because of different term structure of interest rates at
different points of time.

6) Plan cost or plan contribution:

 Initially a fund will start with assets- accrued liability at T=0, so we
can say that assets are liability matched at the beginning.
However , as we move forward in times, there is a definite increase
 in the service length of the employees , thus incurring the accrued
liabilities. Assets in the beginning will not be sufficient to fund
these future liabilities, so employer needs to contribute extra funds
to the plan every year called as plan cost or plan contribution.

 Plan cost = TBO(theoretical benefit obligation)/Max. service

period
 TBO = PV of projected benefit payments assuming that employee
works till retirement(say 40 years)

ASSUMPTIONS
I. Benefit payment = 5 years average salary * 1% * length of service *
COLA (Cost of living adjustment)
II. COLA = (1+ min(5%,80%*inflation rate)
III. Admin expenses- assumed to be included in the benefit payments only.
IV. Mortality ratio - standard mortality rate : to get probability of death or
survival , we consider a mortality table.
V. Mortality improvement ratio - 1% per year
VI. Vesting period : 3 years
VII. Employee data
VIII. Turnover assumptions (When is the employee going to leave?)
Salary growth multiples (for any salary)

Mortality table observations:-

Observation no. 1 - Plot of qx shows that the mortality at older ages are much
larger than at younger ages.
Also, qx plot fails to show the details at younger ages, so sometimes we plot log
of qx.
 Log qx plot shows :
 An infant mortality
 Accidental hump around age 20
 Gradual increase in mortality in middle ages
 Exponential increase in mortality at older ages.
 Plot lx (no. of people alive): -
Plot of lx shows very slight fall until late middle ages followed by a steep
plunge at older ages.
 Plot dx (no. of deaths):-
 Mode at approximate at the age of 80
 i.e. male lives are expected to live for about 80 years
 vast majority of deaths between 60 and 100.

We can also plot dx for males and females and observe that the life expectancy
of females is higher than that of males.
Table 1.6 Important variables used for liability modelling

Interpretation of data

 So we have got the simulated funding ratios and funding surplus

scenarios. Next thing would be to come up with an objective function that
we want to optimise under a set of constraints.
 Traditionally we use a return measure in the numerator and a risk
measure in the denominator and try to maximise that.
 High risk plans will have high expected returns which lead to less plan
contributions. The return measure we will use is the ‘modified funding
ratio’ which penalises high risk plans.
 Modified funding ratio=funding ratio+ DV(plan Contribution)^Low
risk-DV(plan contribution)/(initial plan liability)

 DV(Plan contributions)=Present value of plan contribution

according to chosen asset allocation
 DV(plan contributions)^low risk=P.V of plan contributions if
100% allocation is on Govt bonds

Conclusion(Outcome of research)

Metric Constraints

Minimum funding ratio 0.7

Allocation limits Cannot be higher than 75% on a

single asset class

Time horizon for return and risk 1 year

Confidence level of risk 99%

LDI uses asset modelling at a more in-depth level than standard

market indexes as one strategy among many to reduce pension
liability risk. A more thorough and sophisticated analytic
framework can be employed to reflect the impact of alternative
assets and distinctive asset selection procedures used in LDI.

The LDI benchmark model aims to support more consistent and

logical scenarios that reflect dependency within asset classes and
between assets and liabilities by including macroeconomic
dynamics. To better reflect the reality of LDI strategies and
cyclical economic patterns, the example of an LDI benchmark
model produced in this paper uses fundamental economic
parameters and asset subclass level information. This kind of
model can be utilised to create the benchmark return of LDI
techniques, provide LDI, one of numerous strategies to reduce
pension liability risk, uses more intricate asset modelling than
choosing an asset allocation plan to forecast potential financial
outcomes and future contributions. It is beneficial for risk
assessments and investment decisions.

This report's model is not limited to a single model-based optimal

asset allocation strategy and accommodates a variety of
viewpoints and assumptions regarding real-world markets. The
model can also take into account the unique parameters of a
pension plan, such as the current funding ratio, target funding
ratio, and risk tolerance.
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