Topic 5 Commercial Banks� Asset Liability Management ALM

Document Sample
Topic 5 Commercial Banks� Asset Liability Management ALM Powered By Docstoc
					    Topic 5: Commercial Banks’ Asset-
       Liability Management (ALM)
   Asset-liability management strategies

 Interest rate risk management and hedging

 The concept of duration gap and its limitation

 Using financial futures, options, swaps and other
    hedging tools

 The use of derivatives
       Asset-liability management (ALM) strategies
•    ALM is a series of management tools designed to minimise risk
     exposure of banks, hence, loss of profit and value of banks.
•    ALM comprises all areas related to banking operations – loans,
     deposit, portfolio investment, capital management etc.

     ALM Strategies
    •   There are three ALM techniques
    a) Asset Management Strategy (AMS) – this is a strategy
        concerns with control of incoming funds through the
        determination of loans/credits allocation and their interest
        rates.
    b) Liability Management Strategy (LMS)– deals with controlling of
        sources of funds and monitoring of the mix and cost of deposit
        and nondeposit liabilities – by controlling price, interest rate.
    c) Fund Management Strategy (FMS) – this a a more balanced
        approach of ALM that incorporates both AMS and LMS. The
        basic objectives of FMS are:
    -       The control of volume, mix, and return or cost of both assets
            and liabilities for the purpose of achieving a bank’s goals.
    -       The coordination of asset and liability management as a means
            of achieving internal consistence and maximizing the spread
            between revenue and costs, and minimization of risk exposure.
    -       maximization of returns and minimization of costs from
            supplying services.

           Interest rate risk management and hedging
        • Interest rate risk is a major challenge being faced by banks in
          their ALM.
        • Interest rate is determined by market forces through the
          interaction of the forces of demand for and supply of loanable
          funds (credit).
        • Fluctuations in market interest rate leads to two types of risk in
          banks – Price risk and Reinvestment risks.
o          Measurement of Interest rates
    –          Interest rate can be defined as price of credit or return to capital. Interest
               rate can be measured through:
    I.         Yield to Maturity (YTM) – this equalizes current market value of a loan or
               security with the expected future income such loan could generate. The
               YTM is calculated as :

                           n
                                   E (CFt )          Vn
                     PV                     
                          t 1   (1  YTM ) t
                                                (1  YTM ) n

                     Or

                           n
                                  Pmt t         FV n
                     PV                                                       (1)
                          t 1   (1  I ) t
                                              (1  I ) n

         Where
         PV = current market value of asset
         CF = expected cash flow
         FV = Expected value of asset at maturity
         I = market interest rate
         YTM = the yield to maturity
II.    Bank discount rate (DR) – the rate usually quoted on short-
      term loans and government securities. This calculated as:

 DR = 100 – Purchase price of loan or security
                   100
        X          360                                      (2)
          Number of days to maturity

III. YTM equivalent – this is a means of converting DR to YTM
     and it is calculated as:
       YTM           (100 – Purchase price)        365
      equivalent =       Purchase price     X Days to maturity
      yield                                                (3)
    The Components of Interest rates
     - Interest rate has two components – risk-free interest rate and
       risk premium. That is,

         Market             Risk-free real        Risk premium to compensate
     interest rate           interest rate        lenders who accept risky
         on risky    =      (such as the      +   IOUs for their default (credit)
         loan or           inflation-adjusted      risk, inflation risk, term or
         security          return on              maturity risk, marketability
                         government bonds)        risk, call risk, etc.          (4)

    Working Exercises
1)   Determine the YTM for a bond purchased today at a price of $950 and
     promising an interest payment of $100 each over the next three years
     when it will be redeemed by the issuer for $1,000.
2)   Suppose a money market security can be purchased for a price of $96
     and has a face value of $100 to be paid at maturity. Using DR, calculate
     the interest on the security if it is expected to mature in 90 days.
3)    What is the YTM equivalent for the security in question 2 above?
• Risk Premiums – risk premiums are interest rates
  charged on loans or other instruments in order to
  compensate for certain risks – default-risk, inflation risk,
  liquidity risk, and call risk.
• Yield Curve – graphical representation of variations in
  interest due to differences in maturity, maturity-premium
  – may be upward, downward or horizontal.

    Interest Rate Hedging
    • In response to interest rate risks, banks engage in interest rate
      hedging (IRH).
    • IRH aims at isolating profit from the damaging effects of interest
      rate fluctuations – concentrating on interest sensitive assets and
      liabilities – loans, investment, interest-bearing deposits,
      borrowings etc, thereby, protecting the NIM ratio.
 Interest Rate Hedging Strategies
  - Interest-Sensitive Gap management (IS Gap)
  - Duration Gap management

• Interest-Sensitive Gap management (IS Gap)
   - IS gap deals with analysis of maturity and repricing of interest-
  bearing assets with the aim of matching their values with the value
  of deposits and other liabilities. That is

  Dollar amount of repriceable   Dollar amount of repriceable
   (interest – sensitive)      =      (interest – sensitive)  (5)
    Assets (ISA)                      Liabilities (ISL)

  - A gap will occur if the repriceable ISA ≠ repriceable ISL. That is
       ISG = ISA - ISL;                     >0, < 0                (6)
  - Relative IS Gap ratio

                            IS Gap
       Relative IS Gap = Size of Bank           ; > 0, < 0      (7)
                         (total Assets)

  - Also the ratio of ISA can be compared to that of ISL, in which case
  we have Interest-sensitive ratio (ISR).

      Interest-Sensitive Ratio (ISR) = ISA     ; > 1, < 1     (8)
                                         ISL
o Importance of IS Gap
   -  It helps in the determination of time period when NIM is to be
      managed.
  -   Helps management to set target for the level of NIM – either to
      freeze it or increase it.
  -   Helps in the determination of ISA and ISL.
o Managing IS Gap
     Management response to existence of IS GAP varies depending
      on ability of banks
     Banks can either embark on aggressive or defensive gap
      management.
Expected s in          Best IS GAP Position   Aggressive management
Interest rates              to be                Action
Rising interest rate        Positive IS GAP     Increase IS assets
                                                Decrease IS liabilities
Falling interest rate       Negative IS GAP     Decrease IS assets
                                                Increase IS liabilities


     A defensive management response will seek to set IS GAP to as
      close to zero as possible to reduce expected income
      fluctuations.
     Management response also depends on the nature of risk
      arising from the IS GAP
Positive IS GAP        Expected risk                  Possible management

ISA > ISL         Losses if interest rates fall   1. Do nothing
                                                  2. Extend asset maturities
                                                     or shorten liability maturities.
                                                  3. Increase IS liabilities or
                                                     reduce IS assets


Negative IS GAP       Expected risk                     Possible management
ISA < ISL         Losses if interest rate rise    1. Do nothing.
                                                  2. Shorten asset maturities
                                                     or lengthen liability maturities.
                                                  3. Decrease IS liabilities or
                                                     increase IS assets.
• Duration Gap Management
  - Duration gap deals with the effect of interest risk on the net worth
  of bank, value of its stock.
  - Duration gap is a value- and time-weighted measure of maturity
  that considers the timing of all cash inflows and outflows. It is a
  measure of average time needed to recover the funds committed to
  an investment.
  - Duration gap of a financial instrument is calculated as:
                   n

                   E (CF ) 
                            t
                                 t
                                  (1  YTM ) t
             D   t 1
                           n
                                                             (9)
                              E (CFt)
                          (1  YTM ) t
                         t 1

   where D = time duration of instrument in years, CF = cash flow, YTM
   = yield to maturity of instrument,, and t = time period.
   - Since the denominator is equivalent to current market value or
   price of asset/instrument, then the duration can be re-expressed as:
           n

           E (CF ) 
                  t
                        t
                      (1  YTM )t
   D  t 1                                                   (10)
      Current market valueor Pr ice

- Recall that Net Worth (NW) of a bank is the value of its assets less
the value of its liabilities, that is
      NW = A – L                                         (11)
- This implies that
      NW = A - L                                      (12)
- Duration analysis can be used to stabilize or immunize the market
value of a bank.
- Duration analysis measures the sensitivity of market value of
financial instrument to changes in interest rate. That is
       P = -D x  i
        P           (1+i)                                (13)
- Equation (13) implies that interest rate of a financial instrument is
directly proportional to the duration of the instrument.
o Using Duration to hedge against Interest rate risk

              Dollar-weighted duration       Dollar-weighted duration
                Of asset portfolio           of liabilities                 (14)

       - Duration gap will exist if there is a positive difference between the
         dollar-weighted asset and dollar-weighted liabilities

                                 Dollar-weighted Dollar-weighted
              Duration gap =     duration of asset - duration of
                                  portfolio          liabilities portfolio   (15)

       - Adjustment for leverage is needed because assets usually exceeds
         liabilities. Thus,


 Leverage-       Dollar-weighted Dollar-weighted             Total liabilities
 adjusted =      duration of asset - duration of            X Total assets
 duration           portfolio         liabilities portfolio                   (16)
 gap

        - The large the LAD gap, the more sensitive will be the of a bank’s net
 worth        (equity capital) to a change in market interest rate. LAD gap can be
 positive     or negative.
      - Average duration can also be used to determine the change in the bank’s
            equity
            Since NW = A - L, A/A  [-DA x i/(1+i)], and
            L/L  [-DL x i/(1+ i), then:


                     i                   i       
      NW   DA           A   DL           L            (17)
                   (1  i)              (1  i)    


       - Note that:
       -
If a bank’s LAD Gap is                     And if interest rate:    Net Worth will:
 +ve (DA  DL x (Liabilities/assets)        Rise, fall             Decrease, increase
-ve (DA DL x (Liabilities/assets)          Rise, fall             increase, decrease
zero (DA  DL x (Liabilities/assets)        Rise, fall               No change
        n
            E (CF )  t
       (1  i) t
D A  t 1n
              E (CF )
          (1  i) t
         t 1

        E (CF )  t
     (1  i) t
DL  n                    (17)'
          E (CF )
      (1  i) t
     t 1