2021 Bank Asset and Liability Management

Bank Asset and
Liability Management
Compiled by Ms Gumbo
Introduction
• Asset and liability management entered common usage from the mid-1970s
onwards. In the changing interest-rate environment, it became imperative for
banks to manage both assets and liabilities simultaneously, in order to minimise
interest rate and liquidity risk and maximise interest income.
• ALM can be defined as any continuous management process that defines,
implements, monitors and back tests financial strategies to jointly manage a
firm’s assets and liabilities. More specifically, an ALM strategy is designed to
achieve a financial goal for a given level of risk and under predefined
constraints.
Ms Gumbo L: Lecturer and Personal Financial Management Advisor
Functions of ALM
• Generally, a bank’s ALM function has in the past been concerned with managing the risk
associated with the banking book. This does not mean that this function is now obsolete,
rather that additional functions have now been added to the ALM role. There are a large
number of financial institutions that adopt the traditional approach, indeed the nature of
their operations would not lend themselves to anything more.
• We can summarise the role of the traditional ALM desk as follows:
1. Interest-rate risk management:
This is the interest-rate risk arising from the operation of the banking book, as described
above. Overall the ALM desk is responsible for hedging the interest-rate risk or positioning
the book in accordance with its view
Functions of ALM
2. Liquidity and funding management:
there are regulatory requirements that dictate the proportion of banking assets that must be held as short-term instruments;
the bank should lend making sure that they are liquid enough to quench withdrawals on a daily basis.
3. Reporting on hedging of risks:
The ALM fulfils a senior management information function by reporting on a regular basis on the extent of the bank’s risk
exposure. This may be in the form of a weekly hardcopy report, or via some other medium;
4. Setting up risk limits:
The ALM unit will set limits, implement them, and enforce them, although it is common for an independent “middle office”
risk function to monitor compliance with limits;
5. Capital requirement reporting:
This function involves the compilation of reports on capital usage and position limits as percentage of capital allowed, and
reporting to regulatory authorities.
Functions of ALM
6. FX risk management:
• Effectively understanding, valuing, and managing risks on the balance sheet
• Production of data measures and monitoring of positions against limits set by ALCO
• Managing risk exposure through effective execution
• External market access function
• Review of limit breaches and remedial action.
7. Providing Treasury support:
• Design and implementation of Treasury policies across the business and ensuring compliance;
• Producing analysis and papers for monthly ALCO.
8. Providing Treasury services:
• Proactive support and involvement to new product development and pricing decisions;
• Prudent management of risk in line with bank policies.
Functions of ALM: Liquidity
1. Liquidity
• Liquidity is very important to any institution that accepts deposits because
of the need to meet customer demand for instant-access funds.
• In terms of a banking book the most liquid assets are overnight funds,
while the least liquid are medium-term bonds. Short-term assets such as T-
bills and CDs are also considered to be very liquid.

Functions of ALM: Interest rates
2. Money market term structure of interest rates
• The shape of the yield curve at any one time, and expectations as to its
shape in the short-and medium-term, impact to a significant extent on the
ALM strategy employed by a bank.
• Market risk in the form of interest-rate sensitivity is significant, in the
form of present-value sensitivity of specific instruments to changes in the
level of interest rates, as well as the sensitivity of floating-rate assets and
liabilities to changes in rates.
Functions of ALM
3. Maturity profile of the book
• Matched assets and liabilities lock in return in the form of the spread
between the funding rate and the return on assets.
• The maturity profile, the absence of a locked-in spread and the yield curve
combine to determine the total interest-rate risk of the banking book.

Functions of ALM
4. Default risk
• the risk exposure that borrowers will default on interest or principal
payments that are due to the banking institution.

Liquidity Management
• Liquidity gap
• This is an obvious risk exposure arising because of liquidity mismatch of assets and liabilities.
The maturity terms will not match, which creates the liquidity gap. The amount of assets and
liabilities maturing at any one time will also not match
• Liquidity risk is the risk that a bank will not be able to refinance assets as liabilities become
due, for any reason.
• To manage this, the bank will hold a large portion of assets in very liquid form. A surplus of
assets over liabilities creates a funding requirement. If there is a surplus of liabilities, the bank
will need to find efficient uses for those funds. In either case, the bank has a liquidity gap.
• This liquidity can be projected over time, so that one knows what the situation is each morning,
based on net expiring assets and liabilities. The projection will change daily of course, due to
new business undertaken each day.
• AMsTreasurer could eliminate liquidity gap risk by matching assets and liabilities across each
Gumbo L: Lecturer and Personal Financial Management Advisor
time bucket
• Actually, at individual loan level this is a popular strategy: if we can invest in an asset paying 5.50%
for three months and fund this with a three-month loan costing 5.00%, we have locked in a 50-basis
point gain that is interest-rate risk free.
• However, while such an approach can be undertaken at individual asset level, it would not be possible
at an aggregate level, or at least not possible without imposing severe restrictions on the business.
• Hence, liquidity risk is a key consideration in ALM. A bank with a surplus of long-term assets over
short-term liabilities will have an ongoing requirement to fund the assets continuously, and there is the
ever-present risk that funds may not be available as and when they are required.
• The concept of a future funding requirement is itself a driver of interest-rate risk, because the bank will
not know what the future interest rates at which it will deal will be. So a key part of ALM involves
managing and hedging this forward liquidity risk.
• Simplified ALM profile of a bank

• Corresponding Asset and liability time profile

• Liquidity risk exposure arises from normal banking operations. That is, it
exists irrespective of the type of funding gap, be it excess assets over
liabilities for any particular time bucket or an excess of liabilities over
assets.
• In other words, there is a funding risk in any case, either funds must be
obtained or surplus assets laid off. The liquidity risk in itself generates
interest-rate risk, due to the uncertainty of future interest rates.

Managing the gap
• Matched book
• The simplest way to manage liquidity and interest-rate risk is the matched book approach, also known as cash
matching
• In matched book, assets and liabilities, and their time profiles, are matched as closely as possible. This includes
allowing for the amortisation of assets. As well as matching maturities and time profiles, the interest-rate basis
for both assets and liabilities will be matched. That is, fixed loans to fund fixed rate assets, and the same for
floating-rate assets and liabilities.
• Floating-rate instruments will further need to match the period of each interest-rate reset, to eliminate spread
risk.
• Under a matched book, also known as cash flow matching, in theory there is no liquidity gap. Locking in terms
and interest rate bases will also lock in profit eg a six-month fixed-rate loan is funded with a six-month fixed-
rate deposit. This would eliminate both liquidity and interest-rate risk.
Managing the gap
• Managing the gap with undated assets and liabilities
• A large part of retail and commercial banking operations revolves around assets that do not have an
explicit maturity date however. These include current account overdrafts and credit card balances.
They also include drawn and undrawn lines of credit.
• The volume of these is a function of general economic conditions, and can be difficult to predict.
• Banks will need to be familiar with their clients’ behaviour and their requirements over time to be
able to assess when and for how long these assets will be utilised.
• Another approach is to split the total undated liabilities into a “core” balance and an “unstable”
balance, and place the first in the long-dated bucket and the second in the shortest dated bucket. The
amount recognised as the core balance will need to be analysed over time, to make sure that it is
accurate.
Managing liquidity
• Managing liquidity gaps and the liquidity process is a continuous, dynamic one because the
ALM profile of a bank changes on a daily basis.
• Liquidity management is the term used to describe this continuous process of raising and laying
off funds, depending on whether one is long or short cash that day.
• The basic premise is a simple one: the bank must be “squared off” by the end
• of each day, which means that the net cash position is zero. Thus, liquidity management is both
very short-term, as well as projected over the long term, because every position put on today
creates a funding requirement in the future on its maturity date.
• The ALM desk must be aware of their future funding or excess cash positions and act
accordingly, whether this means raising funds now or hedging forward interest-rate risk.
Managing liquidity
• The funding gap
• A funding requirement is dealt on the day it occurs. The decision on how
it will be treated will factor the term that is put on, as well as allowing for
any new assets put on that day. As funding is arranged, the gap at that day
will be zero. The next day there will be a new funding requirement or
surplus, depending on the net position of the book.

Managing liquidity
• Running a liquidity gap over time, beyond customer requirements, would
reflect a particular view of the ALM desk.
• So maintaining a consistently underfunded position suggests that interest rates
are expected to decline, at which longer-term funds can be taken at cost.
Maintaining an over-funded gap would imply that the bank thinks rates will be
rising, and so longer-term funds are locked in now at lower interest rates. Even
if the net position is dictated by customer requirements (for example, customers
placing more on deposit than they take out in loans), the bank can still manage
the resultant gap in the wholesale market.
• Funding the liquidity gap: examples

• In the second case, the gap is increasing from period 1 to period 2. The
first period is funded with a three-period and a two-period borrowing of
+50 and +200 respectively. The gap at t2 needs to be funded with a
position that is not needed now. The bank can cover this with a forward-
start loan of +390 at t1 or can wait and act at t2. If it does the latter it may
still wish to hedge the interest rate exposure

Maturity of assets and liabilities and Interest
rate risk
• Typically, longer-term interest rates are higher than shorter term rates; that is, it is common
for the yield curve in the short-term (say 0–3year range) to be positively sloping.
• To take advantage of this banks usually raise a large proportion of their funds from the short-
dated end of the yield curve and lend out these funds for longer maturities at higher rates. The
spread between the borrowing and lending rates is in principle the bank’s profit. The obvious
risk from such a strategy is that the level of short-term rates rises during the term of the loan,
so that when the loan is refinanced the bank makes a lower profit or a net loss.
• Managing this risk exposure is the key function of an ALM desk. As well as managing the
interest-rate risk itself, banks also match assets with liabilities – thus locking in a profit – and
diversify their loan book, to reduce exposure to one sector of the economy.
ALM considerations

• The bank could adopt any of the following strategies, or a combination of them:
a) Borrow three-month funds at 5.50% and lend this out in the three-month period at 6.50%. This
locks in a return of 1% for a three-month period.
b) Borrow six-month funds at 5.75% and lend in the six-month at 6.75%; again this earns a locked-in
spread of 1%.
c) Borrow three-month funds at 5.50% and lend this in the six-month term at 6.75%. This approach
would require the bank to re-fund the loan in three months’ time, which it expects to be able to do
at 5.10%. This approach locks in a return of 1.25% in the first three-month period, and an expected
return of 1.65% in the second three-month period. The risk of this tactic is that the three month rate
in three months does not fall as expected by the ALM manager, reducing profits and possibly
leading to loss.
d) Borrow in the six-month at 5.75% and lend these for a three-month period
at 6.50%. After this period, lend the funds in the three-month or six-month
period. This strategy does not tally with the ALM manager’s view, however,
who expects a fall in rates and so should not wish to be long of funds in
three months’ time.

e) Borrow three-month funds at 5.50% and again lend this in the six-month period at
6.75%. To hedge the gap risk, the ALM manager simultaneously buys a 3v6 FRA to lock
in the three-month rate in three months’ time. The first period spread of 1.25% is
guaranteed, but the FRA guarantees only a spread of 15 basis points in the second period.
• This is the cost of the hedge (and also suggests that the market does not agree with the
ALM manager’s assessment of where rates will be three months from now!), the price
the bank must pay for reducing uncertainty, the lower spread return. Alternatively, the
bank could lend in the six month period, funding initially in the three-month, and buy
an interest-rate cap with a ceiling rate of 6.60% and pegged to Libor, the rate at which
the bank can actually fund its book.
Managing Interest rate risk
• interest-rate risk is defined as the potential impact, adverse or otherwise,
on the net asset value of a financial institution’s balance sheet and
earnings resulting from a change in interest rates.
• Risk exposure exists whenever there is a maturity date mismatch between
assets and liabilities, or between principal and interest cash flows.
• Interest-rate risk is not necessarily a negative thing; for instance, changes
in interest rates that increase the net asset value of a banking institution
would be regarded as positive
Managing Interest rate risk:
Sources of interest-rate risk
• There are four primary sources of interest-rate risk inherent in an ALM book.
1. Gap risk is the risk that revenue and earnings decline as a result of changes in
interest rates, due to the difference in the maturity profile of assets, liabilities and
off-balance sheet instruments. Another term for gap risk is mismatch risk.
• Gap risk is measured in terms of short-or long-term risk, which is a function of the
impact of rate changes on earnings for a short or long period.
• Therefore the maturity profile of the book, and the time to maturity of instruments
held on the book, will influence whether the bank is exposed to short-term or long-
term gap risk.
2. Yield curve risk is the risk that non-parallel or pivotal shifts in the yield
curve cause a reduction in NII.
• The ALM manager will change the structure of the book to take into
account their views on the yield curve.

• Basis risk arises from the fact that assets are often priced off one interest rate, while
funding is priced off another interest rate. Taken one step further, hedge instruments are
often linked to a different interest rate to that of the product they are hedging.
• In the US market the best example of basis risk is the difference between the prime rate
and Libor. Term loans in the United States are often set at prime, or a relationship to
prime, while bank funding is usually based on the Eurodollar market and linked to Libor.
• However, the prime rate is what is known as an “administered” rate and does not change
on a daily basis, unlike Libor. While changes in the two rates are positively correlated,
they do not change by the same amount, which means that the spread between them
changes regularly.
• Many banking products entitle the customer to terminate contractual
arrangements ahead of the stated maturity term; this is sometimes referred
to as option risk.
• This is another significant risk as products such as CDs, cheque account
balances and demand deposits can be withdrawn or liquidated at no
notice, which is a risk to the level of NII should the option inherent in the
products be exercised.

The repricing model
• The repricing, or funding gap, model is a simple model used by small (thus most) FIs. This model is essentially a book
value accounting cash flow analysis of the repricing gap between the interest income earned on an FI’s assets and the
interest expense paid on its liabilities (or its net interest income) over a particular period of time. This contrasts with
the market value–based maturity and duration models
• Under the repricing gap approach, commercial banks report quarterly on their call reports, interest-rate sensitivity
reports which show the repricing gaps for assets and liabilities with various maturities: For example,
• 1. One day.
• 2. More than one day to three months.
• 3. More than three months to six months.
• 4. More than six months to twelve months.
• 5. More than one year to five years.
• 6. More than five years.
The repricing model
• A bank reports the gaps in each maturity bucket by calculating the rate
sensitivity of each asset (RSA) and each liability (RSL) on its balance sheet.
• Rate sensitivity means that the asset or liability is repriced at or near current
market interest rates within a certain time horizon (or maturity bucket).
Repricing can be the result of a rollover of an asset or liability (e.g., a loan is
paid off at or prior to maturity and the funds are used to issue a new loan at
current market rates), or it can occur because the asset or liability is a variable-
rate instrument (e.g., a variable-rate mortgage whose interest rate is reset every
quarter based on movements in a prime rate).
The repricing model
• Gap is a measure of the difference in interest-rate sensitivity of assets and liabilities
that revalue at a particular date, expressed as a cash value.
Gap = RSA – RSL
Dollar size of the gap between the book value of rate-sensitive assets and rate-sensitive
liabilities in maturity bucket ᵢ
• Change in net interest income in maturity bucket

The repricing model
Gap and net interest income
The change in NII is given by:
ΔNIIᵢ = GAPᵢ X ΔRᵢ
= (RSAᵢ – RSLᵢ) X ΔRᵢ
where ΔR = Change in the level of interest rates impacting assets and liabilities in the ᵢth bucket
• a negative gap (RSA < RSL) exposes the FI to refinancing risk, in that a rise in these short-
term rates would lower the FI’s net interest income since the FI has more rate-sensitive
liabilities than assets in this bucket. In other words, assuming equal changes in interest rates on
RSAs and RSLs, interest expense will increase by more than interest revenue.
• Conversely, if the FI has a positive $20 million difference between its assets and liabilities
being repriced in 6 months to 12 months, it has a positive gap (RSA > RSL) for this period and
is exposed to reinvestment risk, in that a drop in rates over this period would lower the FI’s
net interest income; that is, interest income will decrease by more than interest expense
• The value of a book with zero gap is immune to changes in the level of interest rates.
The repricing model
Cumulative gap
• The FI manager can also estimate cumulative gaps (CGAPs) over various repricing
categories or buckets. A common cumulative gap of interest is the one year repricing gap
• ΔNIIᵢ = (CGAPᵢ ) X ΔRᵢ
• Consider the simplified balance sheet facing the FI manager in Table 2
• Calculate rate sensitive assets and liabilities
• Calculate one year cumulative gap and change in net interest income
(Instead of the original maturities, the maturities are those remaining on different assets and
liabilities at the time the repricing gap is estimated.)

The repricing model
Cumulative gap
• Rate-Sensitive Assets
• Looking down the asset side of the balance sheet in Table 2 , we see the following one-year rate-
sensitive assets (RSAs):
1. Short-term consumer loans: $50 million. These are repriced at the end of the year and just make
the one-year cutoff.
2. Three-month T-bills: $30 million. These are repriced on maturity (rollover) every three months.
3. Six-month T-notes: $35 million. These are repriced on maturity (rollover) every six months.
4. 30-year floating-rate mortgages: $40 million. These are repriced (i.e., the mortgage rate is reset)
every nine months. Thus, these long-term assets are rate-sensitive assets in the context of the
repricing model with a one-year repricing horizon.
The repricing model
Cumulative gap
Rate-Sensitive Liabilities
• Looking down the liability side of the balance sheet in 2 , we see the following liability items
clearly fit the one-year rate or repricing sensitivity test:
1. Three-month CDs: $40 million. These mature in three months and are repriced on rollover.
2. Three-month bankers acceptances: $20 million. These also mature in three months and are
repriced on rollover.
3. Six-month commercial paper: $60 million. These mature and are repriced every six months.
4. One-year time deposits: $20 million. These get repriced right at the end of the one year
gap horizon.
The repricing model
Cumulative gap
• The four repriced liabilities ($40 + $20 + $60 + $20) sum to $140 million,
and the four repriced assets ($50 + $30 + $35 + $40) sum to $155 million.
Given this, the cumulative one-year repricing gap (CGAP) for the bank is:
CGAP=One-year rate-sensitive assets - One-year rate-sensitive liabilities
=RSA - RSL
=$155 million - $140 million = $15 million

Gap and net interest income
• Gap analysis is used to measure the difference between interest-rate-sensitive assets and
liabilities, over specified time periods.
• Another term for this analysis is periodic gap, and the common expression for each time
period is maturity bucket. For a commercial bank the typical maturity buckets are:
• 0–3 months;
• 3–12 months;
• 1–5 years;
• > 5 years.

The repricing model
Gap ratio
• The Gap ratio is given as:
• Gap ratio measures whether there are more interest-rate sensitive assets
than liabilities. A gap ratio higher than one for example, indicates that a
rise in interest rates will increase the NPV of the book, thus raising the
return on assets at a rate higher than the rise in the cost of funding.
• This also results in a higher income spread. A gap ratio lower than one
indicates a rising funding cost.
Example
• Suppose that rates rise by 1.2 percent on RSAs and by 1 percent on RSLs (i.e., the
spread between the rates on RSAs and RSLs increases by 1.2 percent 1 percent
0.2 percent). The resulting change in NII is calculated as:
• NII = (RSA x ΔRRSA ) - (RSL x ΔRRSL )
=Interest revenue - Interest expense
=($155 million x 1.2%) ($140 million x 1.0%)
=$1.86 -$1.4
=$460,000
Weaknesses of the repricing model
• Market Value Effects- interest rate changes have a market value effect in
addition to an income effect on asset and liability values. That is, the
present values of the cash flows on assets and liabilities change, in
addition to the immediate interest received or paid on them, as interest
rates change. In fact, the present values (and where relevant, the market
prices) of virtually all assets and liabilities on an FI’s balance sheet change
as interest rates change. The repricing model ignores the market value
effect—implicitly assuming a book value accounting approach.

• Overaggregation
• The problem of defining buckets over a range of maturities ignores
information regarding the distribution of assets and liabilities within those
buckets. For example, the dollar values of RSAs and RSLs within any
maturity bucket range may be equal. However, on average, liabilities may be
repriced toward the end of the bucket’s range, while assets may be repriced
toward the beginning, in which case a change in interest rates will have an
effect on asset and liability cash flows that will not be accurately measured
by the repricing gap approach.
• Cash Flows from Off-Balance-Sheet Activities
• The RSAs and RSLs used in the repricing model generally include only the assets
and liabilities listed on the balance sheet. Changes in interest rates will affect the cash
flows on many off-balance-sheet instruments as well. For example, an FI might have
hedged its interest rate risk with an interest rate futures contract . As interest rates
change, these futures contracts—as part of the marking-to-market process—produce a
daily cash flow (either positive or negative) for the FI that may offset any on-balance-
sheet gap exposure. These offsetting cash flows from futures contracts are ignored by
the simple repricing model and should (and could) be included in the model.
• The Problem of Runoffs
• In the simple repricing model discussed earlier, we assumed that all consumer loans
matured in 1 year or that all conventional mortgages matured in 30 years. In reality, the
FI continuously originates and retires consumer and mortgage loans as it creates and
retires deposits. For example, today, some 30-year original maturity mortgages may
have only 1 year left before they mature; that is, they are in their 29th year. In addition,
these loans may be listed as 30-year mortgages (and included as not rate sensitive), yet
they will sometimes be prepaid early as mortgage holders refinance their mortgages
and/or sell their houses. Thus, the resulting proceeds will be reinvested at current
market rates within the year.
Duration model
• Unlike the repricing gap model, duration gap considers market values and the
maturity distributions of a FI’s assets and liabilities.
• Further, duration gap considers the degree of leverage on an FI’s balance sheet as
well as the timing of the payment or arrival of cash flows on assets and liabilities.
Thus, duration gap is a more comprehensive measure of an FI’s interest rate risk.
• Duration gap analysis measures the impact on the net worth of the bank due to
changes in interest rates by focusing on changes in market value of either assets or
liabilities. This is because duration measures the percentage change in the market
value of a single security for a 1% change in the underlying yield of the security).
Duration model
• Consider a loan with a 15 percent interest rate and required repayment of half
the $100 in principal at the end of six months and the other half at the end of
the year. The loan is financed with a one-year CD paying 15 percent interest
per year.
• CF 1/2 is the $50 promised repayment of principal plus the $7.50 promised
interest payment ($100 ½ 15%) received after six months.
• CF 1 is the promised cash flow at the end of the year and is equal to the second
$50 promised principal repayment plus $3.75 promised interest ($50 ½ 15%).

Duration model
• Assuming that the current required interest rates are 15 percent per year,
calculate the present values ( PV ) of the two cash-flows
• CF ½ = 57.50/(1.075)^¹= $53.49
• CF 1 = 53.75/ (1.075)^²= $46.51

Duration model
• duration is the weighted-average time to maturity on the loan using the relative present values of the cash flows as
weights.
• Duration = (W½ X ½ ) + (W1 X 1)

= 0.5349 (½) + 0.4651(1) = 0.7326 years
• while the maturity of the loan is one year, its duration, or average life in a cash flow sense, is only 0.7326 years.
Duration model
• next calculate the duration of the one-year, $100, 15 percent interest certificate of deposit.
• Because all cash flows are received in one payment at the end of the year, W1 PV 1 / PV 1 = 1, the duration
of the deposit is:
Duration = W1 X 1= 1 year
Duration Gap = Maturity of assets – Maturity of liabilities
= .7326 - 1 = - 0.2674 years
• This example
• also illustrates that while the maturities on the loan and the deposit are both
• one year (and thus the difference or gap in maturities is zero), the duration gap is negative
• to measure and to hedge interest rate risk, the FI needs to manage its duration gap rather than its maturity
gap.
Macaulay’s duration
• You can calculate the duration (or Macaulay’s duration ) for any fixed-income security that pays interest annually
using the following general formula
• D Duration measured in years

• CF t Cash flow received on the security at end of period t
• N Last period in which the cash flow is received
• DF t Discount factor 1/(1 + R ) t , where R is the annual yield or current level of interest rates in the market
• Σ = Summation sign for addition of all terms from t = 1 to t = N
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the end of the period t , which equals CF t DF t :
Macaulay’s duration
• For bonds that pay interest semi annually, quarterly etc the duration
equation becomes:
• where m number of times per year interest is paid.

Duration of a Six-Year Eurobond with 8
Percent Coupon and Yield
• Eurobonds pay coupons annually. Suppose a Eurobond matures in 6 years,
the annual coupon is 8 percent, the face value of the bond is $1,000, and
the current yield to maturity ( R ) is also 8 percent.

Duration of a Two- Year U.S. Treasury Bond with 8 Percent Coupon and
12 Percent Yield
• Suppose a Treasury bond matures in two years, the annual coupon rate is 8 percent, the face
value is $1,000, and the annual yield to maturity ( R ) is 12 percent
• duration of a zero-coupon bond equals its maturity Because there are no intervening cash
flows such as coupons between issue and maturity. Note that only for zero-coupon bonds are
duration and maturity equal. Indeed, for any bond that pays some cash flows prior to
maturity, its duration will always be less than its maturity.
Modified duration
• modified duration is Duration divided by 1 plus the interest rate.
• Modified duration = Duration/ (1+R)
• Dollar duration is the dollar value change in the price of a security to a 1
percent change in the return on the security. The dollar duration is defined
as the modified duration times the price of security:
• Dollar duration = MD x P

Modified duration
• Consider the previous example for the six-year Eurobond with an 8 percent coupon and 8 percent yield. We
determined in that its duration was approximately D = 4.993 years. The modified duration is:
• MD = D/(1 + R)
= 4.993/1.08
= 4.623 That is, the price of the bond will increase by 4.623 percent for a 1 percent decrease in the interest
rate on the bond.
• Further, the dollar duration is:
• Dollar duration = 4.623 x $1,000 = 4,623
• or a 1 percent (or 100 basis points) change in the return on the bond would result a change of $46.23 in the price
of the bond.
• Ie – dollar duration x ΔR (4623 x 0.01 = 46.23)
Value-at-Risk
• VaR is a measure of the worst expected loss that a firm may suffer over a
period of time that has been specified by the user, under normal market
conditions and a specified level of confidence.
This measure may be obtained in a number of ways, using a statistical model
or by computer simulation. We can define VaR as follows:
• VaR is a measure of market risk. It is the maximum loss that can occur
with X% confidence over a holding period of n days.

Value-at-Risk
• VaR is the expected loss of a portfolio over a specified time period for a set level of
probability. For example, if a daily VaR is stated as $100,000 to a 95% level of
confidence, this means that during the day there is a only a 5% chance that the loss
the next day will be greater than $100,000.
• VaR measures the potential loss in market value of a portfolio using estimated
volatility and correlation. The “correlation” referred to is the correlation that exists
between the market prices of different instruments in a bank’s portfolio. VaR is
calculated within a given confidence interval, typically 95% or 99%; it seeks to
measure the possible losses from a position or portfolio under “normal”
circumstances
Value-at-Risk
• The main assumption underpinning VaR – and which in turn may be seen as its major
weakness – is that the distribution of future price and rate changes will follow past
variations.
• Therefore, the potential portfolio loss calculations for VaR are worked out using
distributions from historic price data in the observation period.
• VaR is a measure of the volatility of a firm’s banking or trading book. A portfolio
containing assets that have a high level of volatility has a higher risk than one containing
assets with a lower level of volatility.
• The VaR measure seeks to quantify in a single measure the potential losses that may be
suffered by a portfolio.
Value-at-Risk
• The normal distribution curve is used by many VaR models, which assume
that asset returns follow a normal pattern. A VaR model uses the normal
curve to estimate the losses that an institution may suffer over a given time
period. Normal distribution tables show the probability of a particular
observation moving a certain distance from the mean.
• If we look along a normal distribution table we see that at −1.645 standard
deviations, the probability is 5%. This means that there is a 5% probability
that an observation will be at least 1.645 standard deviations below the
mean. This level is used in many VaR models.
Value-at-Risk
Calculation methods
The three traditional methods for calculating VaR are:
• the variance–covariance (or correlation or parametric method);
• historical simulation;
• Monte Carlo simulation.

Value-at-Risk
• Variance–covariance method
• This method assumes the returns on risk factors are normally distributed, the
correlations between risk factors are constant and the delta (or price sensitivity to
changes in a risk factor) of each portfolio constituent is constant.
• Using the correlation method, the volatility of each risk factor is extracted from
the historical observation period. Historical data on investment returns is therefore
required. The potential effect of each component of the portfolio on the overall
portfolio value is then worked out from the component’s delta (with respect to a
particular risk factor) and that risk factor’s volatility.
Value-at-Risk
• VaR using covariance method:
• VaR of a single asset is:
• (The value of the asset) X (Its standard deviation at the desired confidence
level).
• Example
• A delta stock is trading at 120, the standard deviation of 15% and normal
distribution of 95% confidence level is 1.645 standard deviation away from
the mean. Calculate VaR
Value-at-Risk
• VaR = 120 x 0.15 x 1.645
• = 29.61
• VaR of a portfolio
• Generally VaR will not be calculated for a single asset but a portfolio of
assets. In such a case one should calculate VaR volatility.
• VaR ii thus = Portfolio value $ x δp x confidence level
• Where δp standard deviation of a portfolio
Value-at-Risk
Historical simulation method
• The historical simulation method for calculating VaR is arguably the simplest.
• The three main assumptions behind correlation (normally distributed returns, constant
correlations and constant deltas) are not needed in this case. For historical simulation, the
model calculates potential losses using actual historical returns in the risk factors and so
captures the non-normal distribution of risk-factor returns.
• This means rare events and crashes can be included in the results.
• As the risk-factor returns used for revaluing the portfolio are actual past movements, the
correlations in the calculation are also actual past correlations. They capture the dynamic nature
of correlation as well as scenarios when the usual correlation relationships break down.
Value-at-Risk
• Monte Carlo simulation method
• The third method, Monte Carlo simulation, is more flexible than the previous two. As with historical simulation, Monte
Carlo simulation allows the risk manager to use actual historical distributions for risk-factor returns rather than having to
assume normal returns. A large number of randomly generated simulations are run forward in time using volatility and
correlation estimates chosen by the risk manager. Each simulation will be different but, in total, the simulations will
aggregate to the chosen statistical parameters (that is, historical distributions and volatility and correlation estimates).
• This method is more realistic than the previous two models and therefore is more likely to estimate VaR more accurately.
However, its implementation requires powerful computers and there is also a trade-off in that the time required to
perform calculations is longer. The level of confidence in the VaR estimation process is selected by the number of
standard deviations of variance applied to the probability distribution.
• A standard deviation selection of 1.645 provides a 95% confidence level (in a one-tailed test) that the potential estimated
price movement will not be more than a given amount based on the correlation of market factors to the position’s price
sensitivity.

2021 Bank Asset and Liability Management

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Bank Asset and

Ms Gumbo L: Lecturer and Personal Financial Management Advisor

Ms Gumbo L: Lecturer and Personal Financial Management Advisor

Ms Gumbo L: Lecturer and Personal Financial Management Advisor

Ms Gumbo L: Lecturer and Personal Financial Management Advisor

Ms Gumbo L: Lecturer and Personal Financial Management Advisor

Ms Gumbo L: Lecturer and Personal Financial Management Advisor

Ms Gumbo L: Lecturer and Personal Financial Management Advisor

Ms Gumbo L: Lecturer and Personal Financial Management Advisor

Ms Gumbo L: Lecturer and Personal Financial Management Advisor

Ms Gumbo L: Lecturer and Personal Financial Management Advisor

Ms Gumbo L: Lecturer and Personal Financial Management Advisor

Ms Gumbo L: Lecturer and Personal Financial Management Advisor

Ms Gumbo L: Lecturer and Personal Financial Management Advisor

• Change in net interest income in maturity bucket

Ms Gumbo L: Lecturer and Personal Financial Management Advisor

Ms Gumbo L: Lecturer and Personal Financial Management Advisor

Ms Gumbo L: Lecturer and Personal Financial Management Advisor

• The Gap ratio is given as:

Ms Gumbo L: Lecturer and Personal Financial Management Advisor

Ms Gumbo L: Lecturer and Personal Financial Management Advisor

Ms Gumbo L: Lecturer and Personal Financial Management Advisor

• Duration = (W½ X ½ ) + (W1 X 1)

• D Duration measured in years

• where m number of times per year interest is paid.

Ms Gumbo L: Lecturer and Personal Financial Management Advisor

Ms Gumbo L: Lecturer and Personal Financial Management Advisor

Ms Gumbo L: Lecturer and Personal Financial Management Advisor

Ms Gumbo L: Lecturer and Personal Financial Management Advisor

Ms Gumbo L: Lecturer and Personal Financial Management Advisor

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