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 Risk management tools
Insurance
Hedging
Asset liability management
 Average per firm risk

For insured the payment of premium even if

more than IFE is money well spent
Shall result in reduced financing cost
hInsurer͛s per firm risk is small
hIndividual risk of fire are not highly correlated
hPFR= IFE/ Underoot of N
hIFE= Individual firm͛s exposure
(probability of fire X loss resulting from fire)
N = number of firms insured with identical risk
 ±

h Asset liability is a conceptual tool of financial
engineering.
h Asset and liability management is the practice
of `

  that arise due to
mismatches between the assets and liabilities.
h Strategic management tool
To manage interest rate risk
Liquidity risk faced by banks, other financial
services companies and corporations.
  


 


  
h It has changed a great deal over the several decades.
h Until 1960 the deposit taking industries was highly
regulated- implying limited competition-and interest
rate was relatively stable. so that time ALM has not
much role to play.
h But from 1960 when demand from corporate houses
increase. Citibank introduce negotiable certificate of
deposit (non regulated).
h The first asset/liability strategies to develop was
strategies for the management of 
 ` 
.
 ü
h As time went on, ALM become progressively
more aggressive.
h in both 1950 & 1960 decade their were total 16
times interest change. In the 1970 decade their
was 139 times interest change ,as pace
accelerated their was 50 times change in
between oct.1979 to dec. 1980.
h The need of ALM looks more when people start

` 
their fund to earn higher
return else where.
 

 ±
üü 
There are 5 foundation concept to understand
all asset liability strategies management.
h Liquidity
h Term structure
h Interest rate sensitivity
h Maturity composition
h Default risk
h Pension fund-exposed to considerable interest
rate risk
h Policies in various forms
h Most popular ʹ GIC i.e guarantee a fixed
stream of future income to their owners
h Mutual fund- Assets and liabilities
automatically matched
h Timing and amount of cash outflows from
assets match with the amount and timing of
the cash flows from liabilities.
 Dedicated portfolio
h An asset portfolio constructed to precisely
match cash flows
h Extremely difficult if, not impossible
h Very expensive/ may require to leave more
attractive opportunities
h So, what is the solution
 Portfolio immunisation
h F.m Redington in 1952.
h First of all check interest rate sensitivity using
Duration
h Developed by Federick Maculay in 1938
 Duration
h Relative measure of measurement of interest
rate sensitivity of a debt instrument.
h Weighted average of time to instrument͛s
maturity
h Weights are present value of individual cash
flow divided by PV of the entire stream of cash
flows
 problem
h Liability has a present value of $760.61 so
that at each and every point of time in future
the present value of assets is equal to present
value of liabilities.
h Two investment oppoutunities
1. 30 years treasury bonds paying a coupon of 12%
selling at par. (D= 8.08 years)
2. 6 month treasury bills yielding 8%( D= .481years)
Duration concept is not without flaws

h Duration value are reliable for only short

periods of time.
h Durations and yield changes may not be same
for all the instruments.
h A problem with the assumption that all
movements of the yields curve take form of
parrallel shifts.
 Risk says: MAIN HOON NA
h Currency matching strategy eliminates a
large part of risk
h But in repatriation of profits ʹ currency risk
still remains
h So within each currency take portfolio
immunization strategy to counter interest rate
risk.
h Can use hedging
  ±
Liquidity is loosely define as the ease with which asset can be
converted in to cash. their are two dimension to liquidity
h Maturity
h Marketability.

 
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h At any given point there is a relationship between interest
rates on bonds of different maturities. On that basis of
maturity debt instrument are divided into money market
instruments and capital market instruments. Such a relation
can be drawn on two securities having same credit rating
usually depicted in the form of a graph often called a yield
curve.
   

 
There are two ways to look at interest rate sensitivity.
h Degree with which an instrument price will change
with change in yield of security.
h Degree with which change on interest with change in
market rate.
 
ü
h The maturity of asset and liability is matched or not. if
it is matched then the company has spread like bank
give loan of 8000Rs for three years at 10% and
borrowed 6000 Rs for 3 years at 8% and rest borrow for
3 months in that case bank has spread lock of 6000Rs
and spread of 2%.
 ±
 

h Default risk is a risk that the debtor will be
unable to pay the loan principle or interest.
financial institution assess the default risk in
depth and charge their interest rate on the
basis of risk.
 ü

ü


 ±

  
h In earlier days one of the major concern was always
liquidity. since depositors at financial institutions could
withdraw at short notice, so they have to maintain high
cash in liquid form.
h Liquidity management changed dramatically after the
introduction of certificate of deposits like sudden
withdraw will be offset by quick issue of CD͛s.
h Earlier bank keep 50% in cash form then reduce to 45%
then to 30%.
h The CD approach soon replicated with the introduction
of commercial papers.
 
  
1. The essence of modern ALM, in achieving the long term
goal of wealth maximization, is efficient and effective
management of interest margins and spreads. Also
important is the concept of the gap.
The gap may be define as:
h Difference in floating asset rate and floating liability rate.
h Difference in fixed asset rate and fixed liability rate.
h The simple strategy is a simple spread strategy in this ALM
group would look to lock-in spread by matching both the
type.
2. More aggressive strategy is 

`
`
. In gap
management the institution varies the gap in response to
expectation about the future.
 


  
h Spend great time on predicting future rate but
predictions are only predictions.
h All the old problems are enumerated with the
introduction of ï  
 
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h In an efforts to carve out new product niche, a
number of investment banker develop
strategy to assist financial institutions.
h Some strategies succeed, some fail
Two techniques
h Total return optimization
h Risk control arbitrage
 
  

h Total return optimization employs tools from the
management sciences, such as linear
programming, in an efforts to determine the
optimal mix of assets given a set of constraints.
h Suppose a client having five securities treasury
bills, treasury bonds, state bonds, local municipal
bonds and corporate bonds.
h What composition we have to maintain to
maximize our return under giving a set of
constraints.
 
ü

h Risk controlled arbitrage is an effort to
maximize the interest of spread by purchasing
high-yield assets and funding these assets at
the lowest possible cost.
 Forwardate|reement F|
h An OTC contract between parties that determines the
rate of interest, or the currency exchange rate, to be
paid or received on an obligation beginning at a future
start date.
h The terms of the contract :
will determine the rates to be used
termination date
and notional value.
± On this type of agreement, it is only the differential that is
paid on the notional amount of the contract.
Also known as a "future rate agreement".
h Typically, for agreements dealing with interest rates, the parties to
the contract will exchange a fixed rate for a variable one.
h The party paying the fixed rate is - borrower,
h party - receiving the fixed rate is the lender.
For a basic example, assume Company A enters into an FRA with
Company B in which Company A will receive a fixed rate of 5% for
one year on a principal of $1 million in three years. In return,
Company B will receive the one-year LIBOR rate, determined in
three years' time, on the principal amount. The agreement will be
settled in cash in three years.
 after three years'
h LIBOR is at 5.5%,
h Company A pay Company B. This is because
the LIBOR is higher than the fixed rate.
(Mathematically, $1 million at 5% generates $50,000 of interest for
Company A while $1 million at 5.5% generates $55,000 in interest
for Company B. )
h Ignoring present values, the net difference
between the two amounts is $5,000, which is
paid to Company B.
Thanks
FOR YOUR IMPATIENT LISTENING
 üommercialaper
h An unsecured, short-term debt instrument
issued by a corporation, typically
for the financing of accounts
receivable, inventories and meeting short-
term liabilities.
h Maturities on commercial paper rarely range
any longer than 270 days.
h The debt is usually issued at a discount,
reflecting prevailing market interest rates.
h 

 
 

üommercialaper
Commercial paper is not usually backed by any form of
collateral, so only firms with high-quality debt ratings will
easily find buyers without having to offer a substantial
discount (higher cost) for the debt issue.
A major benefit of commercial paper is that it does not
need to be registered with the Securities and Exchange
Commission (SEC) as long as it matures before nine months
(270 days), making it a very cost-effective means of
financing. The proceeds from this type of financing can only
be used on current assets (inventories) and are not allowed
to be used on fixed assets, such as a new plant, without SEC
involvement.
 üertificatefeposit ü
h A savings certificate entitling the r  to receive interest. A CD bears a
maturity date,

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. CDs are generally issued by commercial banks and are
insured.
h The term of a CD generally ranges from one month to five years.
h certificate of deposit is a promissory note issued by a bank. It is a time
deposit that restricts holders from withdrawing funds on
demand. Although it is still possible to withdraw the money, this action
will often incur a penalty.
For example, let's say that you purchase a $10,000 CD with an interest rate
of 5% compounded annually and a term of one year. At year's end, the CD
will have grown to $10,500 ($10,000 * 1.05).
CDs of less than $100,000 are called "small CDs"; CDs for more than
$100,000 are called "large CDs" or "jumbo CDs". Almost all large CDs, as
well as some small CDs, are negotiable.