Asset Liability Management

Asset Liability Management

Florian Ielpo
Sorbonne Economics Center, Dexia SA

Asset Liability Management - F. Ielpo

 General Introduction

Asset Liability Management - F. Ielpo

General Introduction
Classically, a bank supports
several types of risks:
Risk of default
Liquidity risk
Interest rate risk
Exchange rate risk
Market risk
Operational risk
…

Asset Liability Management - F. Ielpo

General Introduction
As part of market activities:
specific risks (market)
As part of the bank's activity (1°
profession), other risks:
Liquidity risk: risk of not being able to meet
its commitments (actual cash flows)
Interest rate risk: risk of not being able to
refinance at the expected rate
Currency risk: risk that the banking product
subsidiaries may be degraded by the movements of
change

Asset Liability Management - F. Ielpo

General Introduction
Simple example:
◦ A local agency lends 100 at 5% for one year to
an individual
Need to refinance 100 with the house
mother
◦ Refinancing of internal transfer vehicles
4.9%
Commercial margin = 0.1%
◦ The parent company must refinance itself on the market
4.85%
Transformation margin = 0.05%
Margin of interest: Commercial margin + Margin of
transformation.
Asset Liability Management - F. Ielpo
General Introduction
In the end:
◦ The parent company centralizes the cash needs and
the financing needs.
0 The difference between the two = the liquidity deadlock
◦ The sensitivity of the rate margin to
rate movements = rate deadlock

We use covering products and a

forecast of liquidity needs to manage
these two dead ends Job of the ALM
The net interest margin of products of
coverage = Net interest margin.
Asset Liability Management - F. Ielpo
General Introduction
Also possible to understand from ALM at
through the dynamics of the balance sheet.
At the moment t, balanced statement
But the dynamics of assets and liabilities do not
are not the same:
Short or long customer needs
Refinancing needs depend on the strategy.
of rate

Asset Liability Management - F. Ielpo

Bank statement Client deposits!

Active Passive
LONG TERM
LONG TERM
Immovables
corporeal Equity
Assets Reserves
incorporeal
Financial investments Results
◦ Operations with customers Provisions RC
◦ Participations/parts
◦ Receivables on
Financial debts
credit institutions long
Court term
COURT TERM
VMP: obligations,
actions... Short-term debts
Divers
Maturities of assets and liabilities can be
different Asset Liability Management - F. Ielpo
General Introduction
In the end:
First constraint: facing deadlines
(with respect to clients and counterparties)
Second constraint: lose as little as possible
money in the interest rate markets
Third constraint: … try to win from
money.
BUT THE ALM IS NOT A CENTER OF
PROFIT !!!
It is natural not to always make money
in ALM.

Asset Liability Management - F. Ielpo

General Introduction
Example:
When interest rates fall and there are needs
of financing
Customer receivable of €100 at 4% for one year

Daily refinancing at 3.8% until ...

3% over one year

The situation is very different if rates rise!

Asset Liability Management - F. Ielpo

General Introduction
In the end:
It all depends on the balance sheet structure: borrower
Are you a lender?

From the maturity of assets and liabilities: macro or

micro treatment?
From the interest rate market context: rising or
decreasing
From the funding policy...

Asset Liability Management - F. Ielpo

General Introduction
Here: we mainly deal with ALM in the
position of the parent company:
Determination of the funding policy (long
term)
Determination of interest rate risk coverage
and liquidity
… le tout d’un point de vu global / agrégé.

Asset Liability Management - F. Ielpo

General Introduction
Course organization:

1) The liquidity risk: measurement and management

2) Interest rate risk: measurement and management

Decision-making tools
4) Positioning of rates, maturity and economy

Asset Liability Management - F. Ielpo

General Introduction
Reading tips
On interest rate products: Martellini, Priaulet and
Priaulet (2003)
On ALM: Introduction to Asset Liability Management
Demey, Frachot and Riboulet (2004) Economica

Asset Liability Management - F. Ielpo

Liquidity risk management

Asset Liability Management - F. Ielpo

The liquidity risk
Liquidity: being able to meet the
liabilities and assets.
Liquidity problems:
On the asset side: opportunity loss, impossibility of
finance a project
In passive: liquidity crisis, deterioration of
name... or worse.

Asset Liability Management - F. Ielpo

The liquidity risk Depends on the
politics
monetary

On the liability side, the financing capacities

come from:
The cash raised from central banks (repo)
Refinancing from the interbank market
Customer deposits: in a normal environment,
constitute a safety mattress
Long-term loans (funding)
Bank capital = Equity + Reserves
(+PRC +Result)
Different levels of demand / maturity...

Asset Liability Management - F. Ielpo

The liquidity risk
On the asset side:

Cash and government bonds, notably eligible for

open market operations (BC) and repo.
Assets traded on organized markets: stocks,
interbank loans...
Customer credit, according to maturities, country of origin,
risk...
Long-term participations and assets difficult to
cede

Asset Liability Management - F. Ielpo

The liquidity risk
And everything that is hidden off the balance sheet:
Options on futures
Interest rate and currency swaps
Forward Rate Agreement and Futures

Who can have an impact on liquidity: calls

daily margin, cash delivery...

Asset Liability Management - F. Ielpo

The liquidity risk
At each present date, the balance is balanced.
by construction.
But in projection: liquidity gap by
maturity
Answer the question: how much cash
will I need/exceed in one year, two
ans…
Calculation of liquidity deadlock =
Assets - Liabilities on the various balance sheet dates
Naturally: at each present date, the balance is
balanced again, at the cost of refinancing
emergency or excessive liquidity if badly
anticipated.
Asset Liability Management - F. Ielpo
Liquidity risk

The knowledge of these needs allows us to

foresee
Long-term funding (hard elimination)
of the need)
Decision-making by the ALM committee for the part
shorter.
As long as the needs are not met by
anticipation interest rate risk!
In ALM: possibility to cover it or not, in
economic/financial diagnostic function.

Asset Liability Management - F. Ielpo

The liquidity risk

Furthermore: static/dynamic distinction:

On date t structure by term of the gaps in
the hypothesis where the bank stops its activity.
In reality: predictable upcoming outstanding amounts in the
future Dynamic liquidity gap:
New productions: new loans and borrowing
Known flows of these new funds.

In short, we can complicate based on the

knowledge that we have of the future.

Asset Liability Management - F. Ielpo

Liquidity risk

The liquidity gap:

For each maturity:

GAP(T) = Liabilities(T) - Assets(T)

GAP>0 more resources than

financing needs.
GAP <0 the opposite: the most concerning case.

Asset Liability Management - F. Ielpo

The liquidity risk

We assume the following balance dynamics:

Year
0 1 2 3 4 5 6 7 8 9 10
s
Active 100 100 100 100 0 0 0 0 0 0 0

Passive 100 80 60 40 40 40 40 40 40 40 40

Gap 0 -20 -40 -60 40 40 40 40 40 40 40

Asset Liability Management - F. Ielpo

The liquidity risk

Asset Liability Management - F. Ielpo

The liquidity risk

Surplus of
liquidity

Asset Liability Management - F. Ielpo

The liquidity risk

Several quantities to know for

to chart its evolution:

The flow function S(t,T)=probability

that 1 € of an outstanding amount entered on date t is
still in the balance as of date T.

The flow rate:

Asset Liability Management - F. Ielpo

Liquidity risk

Homogeneity if these two quantities do not

depend only on T-t.

Flow rate: 10% means that 10%

of the outstanding amount evaporates each year (in base
annual).

Macro dimension rather than micro: stock

global.

Asset Liability Management - F. Ielpo

The liquidity risk

The flow rate depends on:

The bank's trade policy
Competition
The economic situation
The state of financial markets...

To name just a few elements...

And beware of hidden options in loans...

Asset Liability Management - F. Ielpo

Liquidity risk
The deadlock of static liquidity:

In dynamics, we add the productions

news and their flow:

Asset Liability Management - F. Ielpo

The liquidity risk
Liquidity is strictly regulated by law
(cf. DFR 2003)
Liquidity ratios:
availability or one-month assets / repayable liabilities
in one month >100%
Equity ratio:
FP/Debt over 5 years >60%

And many others too...

Asset Liability Management - F. Ielpo

 Interest rate risk

Asset Liability Management - F. Ielpo

Interest rate risk
The liquidity gap:
Uncertainty about its financing if negative
Uncertainty about its use if positive
Car :
Variation of collateralized rates
Existence of variable rate operations
…
But these variations are not necessarily
damaging: structure of the balance sheet,
deadlines...

Asset Liability Management - F. Ielpo

 Interest rate risk
The interest rate risk in ALM:
Uncertainty of the result's term structure
from the bank due to future variations in rates

Different from trading logic and the mark-

to-market

Uncertainty about Uncertainty about

the evolution of the the evolution of
risk premium discount factors

Uncertainty about
future flows
negligible
for FIS)
Asset Liability Management - F. Ielpo
The interest rate risk
The deadlock of rates:

structure by term of the sensitivities of the result

future to the future realized rates.

Interest margin for maturity

Remuneration rate
composites
Asset Liability Management - F. Ielpo
 Interest rate risk
Interest margin after refinancing:

Party
uncertain
of the
income
from the
bank
Future rate
compound interest
Liquidity gap
Asset Liability Management - F. Ielpo
The interest rate risk
A quick calculation gives:

Expression of interest rate risk in the form of

sensitivity
R(T) is unknown probability VaR

Asset Liability Management - F. Ielpo

The interest rate risk
We can cover this interest rate risk using
Swap
Futures
Options on Futures
FRANCE
…

Asset Liability Management - F. Ielpo

The interest rate risk

Position
lender :
risk related to
the increase
rates
Asset Liability Management - F. Ielpo
The interest rate risk
Specifically, only fixed rate operations
are a source of risk.
The rate gap or deadlock corresponds to the
difference of these fixed rate operations:
By maturity
Active vs Passive
Another way to say it: rate gap = gap of
liquidity on fixed rate operations
Indeed: variable rate no additional cost for
refinancing

Asset Liability Management - F. Ielpo

Interest rate risk
Some numerical examples to establish the
ideas:
Active: a bullet loan for 2 years with a nominal value of €100 with

fixed rate 5%
? Liabilities: loan 1 year 80€ at 3% and equity 20€

Liquidity gap?
Rate gap?

Asset Liability Management - F. Ielpo

Interest rate risk
Gap
Actif Passif Gap Rate
Liquidity
Year 1 100 € 100 € 0 0
Year 2 100 € 20 € -80 € -80 €

Asset-Liability Management - F. Ielpo

Interest rate risk
With variable rates
Active: loan in fine for 2 years with a nominal of €100
fixed rate of 5% for the first year and rate
variable for the second year.
Passif : emprunt 1 an 80€ pour 3% et FP 20€

Liquidity gap?
Rate gap?

Asset Liability Management - F. Ielpo

Interest rate risk
Gap
Actif Passif Gap Rate
Liquidity
Year 1 100 € 100 € 0 0
Year 2 100 € 20 € -80 € 0€

No
risk of
rate
since
rate
variable!

Asset Liability Management - F. Ielpo

Interest rate risk
Overall, MNI does not depend on
variable rate operations.

Asset Liability Management - F. Ielpo

The interest rate risk
One can trace a gain profile produced by
product:
Swap IRS
FRA/Futures

Asset Liability Management - F. Ielpo

Interest rate risk
One can draw a gain profile produced by
product:
Swap IRS
FRA/Futures

Important for establishing a strategy of

interest rate risk coverage

Asset Liability Management - F. Ielpo

The interest rate risk
Swap rate:
Payor or borrower swap = pays fixed rate and
receives variable rate
Swap receiver or lender = pays variable rate and
receives the fixed rate
Loan borrowing operation for a nominal
fictitious: the interest rate risk depends on the
fixing frequency of the variable (E3M, E6M...).

Asset Liability Management - F. Ielpo

Interest rate risk
Swap borrower for counterparty A

Capital

Capital

Counterparty A Counterparty B
Pay
rate
fix
Receive
rate
variable

Asset Liability Management - F. Ielpo

The interest rate risk

Swap rates:
No liquidity deadlock
Rate deadlock for the next fixing date

Example:
Swap borrower for a nominal of 100€ 1 year
Fixed rate 5%
3M Euribor variable rate

Asset Liability Management - F. Ielpo

Interest rate risk

Asset-Liability Management - F. Ielpo

Interest rate risk

FRA and Futures (Euribor, Eurodollar...)

allow to lock in the rates from today
from tomorrow
No nominal exchange: the notional is fictitious
Euribor buyer receives the fixed rate and
pay the variable
Buyer of a FRA receives the variable and pays the fixed.
fix
Pay attention to the quotation conventions...

Asset Liability Management - F. Ielpo

The interest rate risk

Euribor futures buyer

Quote 96.5 on the market
Notional €100 (agreement)
3 months in 3 months
Liquidity gap and interest rate gap of a buyer?

Asset Liability Management - F. Ielpo

Interest rate risk

Asset Liability Management - F. Ielpo

Interest rate risk
Things can be even more
complicated
Livret A and indexing to inflation
PEL and random loan start dates
Flow rate of visible deposits
Client loans and hidden options

Other possible managements:

Management in terms of NPV
Management in terms of sensitivities

Asset-Liability Management - F. Ielpo

Interest rate risk
The NPV: net present value of future cash flows
Calculate with a closed Gap using the
forward curve by time bucket (+ or -
summary
VAN of a zero interest rate operation
VAN=Actif*(TA-TM)*DF-Passif*(TP-TM)*DF
Sensitivity = Delta VAN as a function of TM
Classic critiques + loss of temporality.

Asset Liability Management - F. Ielpo

Some remarks
The rate gap is the liquidity gap of
fixed-rate operations
The sign of the rate gap is therefore that of the gap
of liquidity
A positive gap corresponds to a position
lender
A negative gap corresponds to a position
borrower

Asset Liability Management - F. Ielpo

Some remarks
Completely different situation for the margin
of interest
A positive margin indicates a gain:
difference between asset (source of gains) and
passive (cost source)
The interest margin is related to the rate gap.
but these are two different concepts

Asset Liability Management - F. Ielpo

 Take a position in ALM

Knowing the market expectations for the future of

central bank rate

Asset Liability Management - F. Ielpo

ALM and BC rates
Relationship between swap rates and central bank rates
Empirical link:
Depends on maturity
Depends on the considered period (conundrum)
Depends on the currency
Depends on the degree of market independence and its
relation to the US
Depends on the central banker
Theoretical link:
Expectation hypothesis
Capitalization and the principle of non-arbitrage

Asset Liability Management - F. Ielpo

ALM and BC rates: the US case

Asset Liability Management - F. Ielpo

ALM and BC rates: the US case

Asset Liability Management - F. Ielpo

ALM and BC rates: the US case

Asset Liability Management - F. Ielpo

ALM and BC rates: the US case
Short rates:
Strong link to BC rates
Up to two years
Long rates:
Little related to short rates
Greenspan conundrum
It also exists in the euro case.

Asset Liability Management - F. Ielpo

ALM and BC rates: the Euro case

Asset Liability Management - F. Ielpo

ALM and BC rates: the Euro case

Asset Liability Management - F. Ielpo

ALM and BC rates: the Euro case

Asset Liability Management - F. Ielpo

ALM and BC rates: the Euro case

Asset Liability Management - F. Ielpo

ALM and BC rates: the Euro case

Asset Liability Management - F. Ielpo

ALM and BC rate: the Euro case
Movements of 25 bp in most of the
case
Same behavior as the dollar rates
Short rates linked to monetary policy
Taux longs globalement peu connectés
A different management of the two types of rates

Asset Liability Management - F. Ielpo

Swap rates and monetary scenario
Using the relationship between ZC rates, YTM and
forward rates

We calculate the 1-day forward rates in x days

With x the number of days until the next

central bank meeting

... and we round to 25 bp closer

Expectation hypothesis: forward rates are
forecasts of future rates

Asset Liability Management - F. Ielpo

Swap rate and monetary scenario
Difficulties:

The swap rates are couponed: determine the ZC

at par rates
Daily base problems
Liquidity of swaps?
Update frequency of the tool?

Asset Liability Management - F. Ielpo

Swap rates and monetary scenario
Difficulties:

What model for forwards?

No model? Rounding of spot rates to 25bp
Use the forward/spot relationship without a model
Use a parametric model of the yield curve:
Nelson and Siegel extended family
Result depends:
From the period
Data used: US/EUR
From the calibration
Used products!

Asset Liability Management - F. Ielpo

The extended Nelson-Siegel family
Basic reminders about the spot forward link
We note the starting forward tau and the residual duration.
tau*

The instant forward is then:

By no arbitrage, the spot is then

Asset Liability Management - F. Ielpo

The extended Nelson-Siegel family
Basic reminders about the spot forward link
The price of a ZC in this continuous context:

Every model is consistent with the forward curve.

instantaneous leads to a more or less spot curve:
Complex
Realistic

To make it short: Nelson and Siegel vs. Svensson.

Asset Liability Management - F. Ielpo

The extended Nelson-Siegel family
Nelson and Siegel
A forward curve with a hump, defined by
lambda and the beta:

By no arbitrage, the spot is worth:

The key interest rate is:

And the long rates:

Asset Liability Management - F. Ielpo

The expanded Nelson-Siegel family
Svensson
A two-humped forward curve:

By no arbitrage, the spot is worth:

Asset Liability Management - F. Ielpo

The extended Nelson-Siegel family
In NS, impact of parameters on the curve:

Asset Liability Management - F. Ielpo

The expanded Nelson-Siegel family
In Svenson, impact of parameters on the curve:

Asset Liability Management - F. Ielpo

The extended Nelson-Siegel family
Main problem with these models: the
jumps in the parameters of a day on
the other

Asset Liability Management - F. Ielpo

The extended Nelson-Siegel family

Asset Liability Management - F. Ielpo

Swap rates and monetary scenario
Difficulties:
Which products to use?
Only swap rate?
Only Futures Rates?
A contract every three months
But very liquid contracts
Update frequency?
Forward rates form a biased prediction
future rates: term premium
In the US, Piazzessi
In Euro, Coffinet

Active-Passive Management - F. Ielpo

The term premium

Asset Liability Management - F. Ielpo

The term premium

Asset Liability Management - F. Ielpo

The term premium

Asset Liability Management - F. Ielpo

The term premium
Term premium:
Depends on the asset used to calculate it:
Fed fund futures
Eurodollar or Euribor futures
It is counter-cyclical

Is negative on average when interest rates rise and

positive otherwise
The rates therefore insufficiently anticipate the increases and
the drops: critique of the EH.

Asset Liability Management - F. Ielpo

Instantaneous forward rate and central bank rate

The model provides the forward rates

monetary instantaneous

Correction for spread refi-jj

In the end:
Forward interest rate = Refi spread jj + Target Bank
Central

Observation of the "monetary scenario" day by day

day
Asset Liability Management - F. Ielpo
Geoffroy in the text… 07/21/2006 Euro

Asset Liability Management - F. Ielpo

Geoffroy in the text… 08/22/2006 Euro

Asset Liability Management - F. Ielpo

Geoffroy in the text… 07/21/2006 Dollar

Asset Liability Management - F. Ielpo

Geoffroy in the text… 08/22/2006 Dollar

Asset Liability Management - F. Ielpo

Instantaneous forward rate and central bank rate

The model provides the forward rates

monetary instantaneous

Correction for spread refi-jj

In the end:
Forward rate inst. = Refi spread jj + Target Bank
Central (25bp)

Observation of the "monetary scenario" day by

day
Asset Liability Management - F. Ielpo
A step further...
Using information in option prices:

Second derivative of the price of the European call option by

regarding the strike:

But the risk-neutral distribution is not there.

distribution of expectations!

Asset Liability Management - F. Ielpo

A step further...
Link between subjective distribution and
anticipations
Radon Nikodyn

Logarithmic derivative:

Result:
D. subjective=distribution RN x correction
for risk aversion!
Asset Liability Management - F. Ielpo
A step further…
In practice:
giving shape to risk aversion is
difficult
Requires many assumptions
Make the model more complicated to estimate
... In short, it may be a lot of noise for
rien!
For monetary policy:
Rarely used
The available options are: options on futures (US)
and swaptions additional difficulty
But we still tried.
Asset Liability Management - F. Ielpo
A step further…
With BS, when the volatility depends on the strike:

Morality: estimation of a cubic spline and

derivation from the SMILE of the RN density

And it is already very refined... (but be careful with the

queues of smiles and therefore distributions RN)
Asset Liability Management - F. Ielpo
A step further...

Asset Liability Management - F. Ielpo

A step further...

Asset Liability Management - F. Ielpo

A step further…
But RN <> of subjective:

Asset Liability Management - F. Ielpo

A step further...
In the end:
Possible to follow market expectations
Day by day
Maturity by maturity
Currency by currency!

But:
Knowing the market scenario is not
sufficient
One must be able to judge whether the market is right
You twist in his BC rate predictions!

Asset Liability Management - F. Ielpo

A step further...
But RN <> subjective:

Asset Liability Management - F. Ielpo

 BC rate and economy

Asset Liability Management - F. Ielpo

Economy and taking a stand
Central banks shape their decisions based on
economic indicators
Their mission: to control expectations
of inflation
The main indicators:
CPI
M3 (Eurozone)
NFP: job creations (US)
+ various anticipation indicators:
ISM/PMI
IFO/ZEW (Europe)
…
Asset Liability Management - F. Ielpo
Economy and position taking
Useful for two types of tasks:

To determine the main directions of the policy

monetary (and therefore the LEVEL of rates): orientation
long-term positions

To determine the right time to implement

interest rate strategies: market timing

But many economic indicators!

Difficult to sort.

Asset Liability Management - F. Ielpo

Economy and positioning

Asset Liability Management - F. Ielpo

Economy and positioning

Asset Liability Management - F. Ielpo

The Taylor rules
The simplest way to explain the rates: the
Taylor rule

Asset Liability Management - F. Ielpo

Taylor's rules
The simplest way to explain rates: the
Taylor rule

Asset Liability Management - F. Ielpo

The Taylor rules
The simplest way to explain rates: the
Taylor rule:

Model errors by stable

Mask two problems:
the level chosen by the BC
The moment of the rate change
In the Eurozone: dependence on the US

Asset Liability Management - F. Ielpo

Market Timing and announcements
macroeconomic

Gestion Actif Passif - F. Ielpo