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LECTURE 3: Asset–Liability Management II - Coggle Diagram
LECTURE 3: Asset–Liability Management II
Introduction
the role of an ALM desk is to help banks manage their loan book and spread between borrowing and lending rates.
Basic concepts
Interest margin: spread between the interest earned on assets and that paid on liabilities.
Interest gap: the cornerstone of modern-day ALM
Interest-rate risk and source: Banking book
Income risk
risk of loss of income when there is a nonsynchronous change in deposit and funding rates (gap risk)
Sources of interest-rate risk
Gap risk: 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.
Yield curve risk: risk that non-parallel or pivotal shifts in the yield curve cause a reduction in NII.
Basis risk: arises from assets are often priced off one interest rate, while funding is priced off another interest rate.
Runoff risk: associated with the non-interest bearing liabilities (NIBLs) of such banks.
Option risk: Many banking products entitle the customer to terminate contractual arrangements ahead of the stated maturity term
Investment risk
potential risk exposure arising from changes in the market value of fixed interest-rate cash instruments and off-balance sheet instruments (Price risk)
The ALM desk
ALM unit has a profit target of zero, it will act as cost center with responsibility to minimize operating costs.
It is responsible for minimizing the cost of funding.
Final stage of development is to turn the ALM unit into a profit center, with responsibility for optimizing the funding policy within specified limits.
Liquidity and interest-rate risk
Liquidity gap: differences between the assets and liabilities
Gap risk and limits:
Marginal gap: difference between the changes of assets and liabilities over a given period.
Gap profile: tabulated or charted (or both) during & at the end of each day as a primary measure of risk.
Limits on a banking book can be set in terms of gap limits.
Critique of the traditional approach
The repricing intervals chosen for gap analysis are ultimately arbitrary; mismatches within a repricing interval.
Interest rates change by a uniform magnitude and direction.
Principal cash flows do not change when interest rates change.
The cost of funding
a profit center arrangement, with the Treasury desk responsible for market-making of money market instruments & being expected to position the bank’s ALM requirement & trade money markets to profit.
Some institutions set the Treasury function up simply to arrange the firm’s funding requirement, so it is not expected to generate profit.
Trading approach
The yield curve and interest rate expectations
funding short
creating a tail
funding long
Repo market specials trading
Factors becoming special include: government bond auctions; outright short selling; hedging; derivatives trading.
Matched book trading in repo
taking a view on interest rates
taking a view on specials
credit intermediation
Hedging tools
repo trader may need to hedge
exact offsetting trade