What is the ALM process?
What does the ALM process entail? Which risks are managed through the process? In this introduction to Asset Liability Management, we define the ALM process and the risks that it addresses.
Asset Liability Management (ALM) involves taking decisions and actions regarding assets and liabilities in an integrated manner in order to manage the business of the entity and meet the organization’s financial objectives. The ALM process is a continuing one that involves formulating, implementing, monitoring and revising strategies related to its assets and liabilities keeping in mind the entity’s risk tolerances and constraints.
The ALM process is essential and critical for any organization that invests to meet its future cash flow needs and capital requirements. The traditional application of ALM primarily dealt with managing risks associated with interest rate changes. But today ALM has a much wider focus. It encompasses equity risk, liquidity risk, legal risk, currency risk, and sovereign or country risk. The traditional Asset Liability Management tools match duration and convexity on a weighted average basis. More recent tools integrate Value at Risk (VaR) concepts into ALM. Reports like Earnings at Risk, Cost to Close and Capital at Risk are representative of the latter.
In this introduction to asset liability management, we will look at two types of risks. Interest rate risk (in particular interest rate mismatch risk) and liquidity risk.
Primary risks managed through the ALM process
Interest Rate Risk
Interest rate risk is the risk to earnings and/ or capital arising from changes in the interest rates. There are four primary sources of interest rate risk. They are:
Re-pricing or Maturity Mismatch Risk arises from timing differences in the maturity and re-pricing of on & off balance sheet items. On balance sheet items include assets and liabilities.
Yield Curve Risk arises from unanticipated shifts in the yield curve. The shift indicates a change in the relationship between the interest rate of different maturities relating to the same market.
Basis Risk arises from the imperfect correlation between earned and paid rates on instruments having similar maturities and re-pricing characteristics. This imperfect correlation results in unexpected changes in cash flows and earning spread.
Option Risk arises from the right to alter the level and timing of cash flows when interest rates change. An option holder or seller will usually exercise the right to the detriment of the entity. Options can be on an asset, liability or off-balance sheet item.
Liquidity risk is the risk of potential loss to an entity due to the non-availability or insufficiency of liquidity. An entity fails to meet its financial commitments and obligations in two ways. 1) Due to its inability to convert assets into cash or 2) Because it cannot obtain enough funds at a reasonable cost. Liquidity risk may also arise because of a market disruption or liquidity squeeze. These events hamper the entity’s ability to sell its exposures or to do so at a loss or significant discount.
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