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Level 57

Asset Liability Management


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Asset Liability Management (ALM)
A structural decision making process for matching and mismatching the mix of assets and liabilities
Prior to the 1970's
Mismatches were not a big problem since interest rates in developed countries were not volatile
Between the 1970's and 1980's
Volatility of interest rates increased, especially with the abandonment of Regulation Q that capped interest rates
S&L in the early 1980's
Suffered huge losses as they had to refinance their fixed rate long term assets by borrowing from depositors at higher rates
Over 1700
During the 1980's how many S&Ls failed due to inadequate risk management?
duration
same as interest rate risk
Duration (Movement)
The percentage change in the value of your portfolio per 1% change in interest rates
A portfolio which has a duration of 3 years
Will decline about 3% for each 1% increase in interest rates
A portfolio which has a duration of (-2) years
Will rise about 2% for every 1% increase in interest rates
Convexity
Use when measuring bond sensitivity to large parallel shifts in the yield curve (but still parallel shifts)
GAP Analysis
Helps address non-parallel shifts in the yield curve such as bends and
Macaulay Duration
If the yield on a bond is measured with continuous compounding
Modified Duration
If the yield on a bond is measured with other compounding frequency
Duration Matching (Immunization)
To avoid exposure to parallel spot curve shifts, an institution with significant fixed income exposures wants to match the duration of its liabilities (so the two offset)
Duration - Convexity Matching
Assets are structured so that durations and convexities match (more effective but less frequently practical)
Does not identify mismatches within buckets
Why has Gap analysis largely fallen out of use?