Selected ALM ISSUES
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Selected ALM ISSUES JF. Boulier - CCF - Directeur de la Recherche et de 1'Innovation C. Chambron - CCF Gestion - Inginieur financier Credit Commercial de France 103, avenue des Champs ElysCes 75008 Paris TBI : 01 40 70 32 76 Fax: 01 40703031 The authors wish to thank K. Seridi for her help with Part 11. Contents Introduction I. ALM: background and current issues I. 1 Description 1.2 Background 1.3 Methods 1.4 Current issues 11. Riding the yield curve 11.1 Defining and analysing the strategy 11.2 Leverage 11.3 Future-rate expectations and persistence effect 11.4 Empirical test 11.5 Observations and conclusions 111. Capital allocation 111.1 Optimising a business portfolio 111.2 One bank, two lines of business 111.3 Applications: Should commercial banks practise transformation? 111.4 Implementation and criticisms 111.5 Pertinent findings IV. Sensitivity of a life insurer's earnings to asset allocation IV. I Life insurers' portfolios: current situation in France IV.2 Accounting mechanisms for appropriation of earnings IV.3 Simulation assumptions IV.4 First simulation: portfolio with a 10% equity element IV.5 Simulation of different investment policies 1V.6 Investing in equities Conclusion Bibliography Introduction Moreover, the achievements of ALM are beginning to find an audience beyond the The technique known as assetAiability inner circle of specialists. In France, two management (ALM) has enjoyed recent examples are significant. remarkable popularity in recent years. From its origins as an actuarial and cashflow When AGF, an insurance company, was matching technique, ALM has grown into a privatised, the chairman stressed the conceptual framework for financial importance of strategic asset allocation for management - and a professional activity boosting profitability and market value. In in its own right. a totally different vein, the mainstream press covered the unfortunate consequences In a world governed by financial markets of Credit Lyonnais' failure to hedge its and physical commodities, it is vital to interest-rate risk. It was reported that analyse objectively the economic effects of Consortium de R&ulisution (CDR), the price movements on balance sheets, defeasance vehicle set up to handle the sale earnings growth and enterprise value. The of the bank's assets, repaid a loan whose constituency of ALM users goes beyond interest rate was pegged to short-term financial institutions and banks, and now interest rates, which have fallen by a steep includes pension funds. In the near future, 5% in the past two years. Given the patchy companies are bound to adopt it. And information at our disposal, we cannot say individuals will surely find it attractive for with certainty whether the indexing was investment decision-making and income deliberate (unlikely, because it would planning. imply a bet on a short-rate hike) or whether it corresponded to other areas of balance ALM specialists are now recognised as sheet exposure. Whatever the reason, the fully-fledged professionals. In the banking fact that the incident was attributed, rightly industry, they have found a niche between or wrongly, to poor ALM shows that an capital market divisions and management informed audience is also aware of this new control divisions (in France) or alongside discipline. strategic divisions (in other European countries). They have also carved a place CCF did pioneering work in adapting ALM for themselves in public life, as witnessed methods to the French environment. A by the constant stream of seminars and feasibility study was carried out in the conferences devoted to ALM, either period 1985-86, shortly after France directly or indirectly. Professional bodies deregulated its money market. In 1987, a are thriving in several countries, including prototype unit began laying the AFGAP in France, NALMA in the USA groundwork for ALM and adapting the and ALMA in the United Kingdom. Lastly, tools that the bank would later need. But it and significantly, ALM is now being taught was not until 1989 that the asset-liability not only as part of a broader curriculum but department actually implemented an also as a discipline in its own right. It is original approach based on the also the subject of numerous books, development of proprietary information including those by J. Bessis (1995) and M. systems. CCF's Research and Innovation Dubernet (1996), and a special review, Department (DRI) has investigated the "Balance Sheet". possibilities of either applying ALM to banking requirements or adapting the underlying concepts to other environments. Some of the DRI's research has been bankers, we intend to start with their outlined in various issues of Quants or at concerns before moving on to other scientific financial conferences. The areas specialist fields such as insurance and covered include securitisation and pension financing. We have divided this prepayment options (Quants No. 4, Andria part into four sections: the first attempts to et al., 1991), embedded options (Boulier define the aims of ALM; the second and Schoeffler, 1992, Boulier, 1996), and retraces its history and examines the role the modelling of dynamic management played by associations such as AFGAP; the with stochastic interest rates (Jerad and third draws up a list of the most commonly Sikorav, 1992). Quants No. 12 examined used methods (without relying on an ALM-based methodology for pension mathematical formalisation); and the fourth fund investment strategies (Boulier et al, examines some of the challenges currently 1995 and 1996) while Quants No. 23 facing practitioners of ALM, particularly in explained how fuzzy calculus could be used terms of methodology. to take account of unknown due-dates in a cashflow matching context. 1.1 Description The purpose of this issue is to examine, in the most accessible way possible, the key Asset-liability management has three main issues involved in ALM and its application. aims, which vary in importance depending We provide three examples of how the on the businesses that use the technique and technique relies on financial modelling. on their maturity. The aims are to analyse Through these case studies, which deal economic risks (chiefly market risk), to with different fields (and can be read choose appropriate strategies (e.g. whether separately), we hope to illustrate the to hedge exposure) and to monitor the diversity of techniques and applications of implementation of those strategies. For ALM. First, we discuss the advisability of companies, the main concern - in theory - exposing a company to interest rate risk - a is to maximise shareholder value. In highly topical theme in view of the current practice, however, this can vary depending yield-curve configuration in Europe. We on how the company's shareholders, then give a description of a capital creditors and management view the process allocation method based on the Markowitz of maximisation. In other words, the model. Finally, we rely on simulations to company's exposure must be decided upon analyse the attractions and risks of rationally, accepted by all those concerned, increasing the equity investments of a life and be applied optimally. This all goes to insurance company. show the importance of information processing, both internally depending on the type of products and the volumes handled, and externally depending on the I. ALM: background and market opportunities involved. Moreover, current issues the overriding concern of ALM teams is the quality of their information, which must be This part of our study examines, in an exhaustive, accessible and easy to model. intentionally non-technical manner, the principal aspects of asset-liability management in its present form in Europe. Since the principal users of ALM are a) Analysis interest rate risk, sometimes called transformation risk. When analysing market risk, commercial banks traditionally focus on three types of Liquidity risk - the bane of every banker's exposure: interest rate risk, currency risk life - is more difficult to identify and and liquidity risk. Later on, we will look at measure. In a nutshell, liquidity risk is the other risks (e.g. credit risk) and how they danger of not finding a lender in the interact (counterparties, embedded market. In practice, the aim is to avoid options). For domestic banks, only the first paying too dearly for liquidity, with the and third types have any direct ultimate risk being that the market will not consequence. Interest rate risk stems from lend money under any circumstances or at the fact that interest rates paid to depositors any price. What are the underlying and yields earned on loans can change at mechanisms? The state (the benchmark different speeds. Take the example of a issuer) borrows for a given period and at a bank that grants a long-term loan at a tixed certain rate. Private issuers such as banks rate of interest and refinances it with borrow at a higher rate, which includes a deposits (which involves collection costs) margin. This is because they are prone to and certificates of deposit (market rates). default -unlike the state, which can always There is no certainty that the interest it pays raise taxes to pay off its debts. The margin, will be lower than the interest it receives. therefore, is the incremental cost to the This risk shows up in many ways: in issuing bank and reflects either investor accounting flows (net banking income), the perception of its creditworthiness or the market value of the bank's products, in degree to which investors are already futures contracts (which depend on the saturated in credit risk. In an initial horizon) and, naturally, in share and bond approximation, that margin is the annual prices. Moreover, depending on the probability of default multiplied by the product, interest rate risk manifests itself in collection rate (corresponding to what the very different ways. This can be seen in the issuer's default would cost the investor) simple example of fixed-rate and variable- plus a risk premium, which depends on the rate loans.