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. It is a continuing process that involves formulating, implementing, monitoring and revising strategies related to its assets and liabilities keeping in mind the entity’s risk tolerances and constraints.
ALM is an essential and critical process 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 encompassing equity risk, liquidity risk, legal risk, currency risk and sovereign or country risk. The traditional Asset Liability Management tools matched duration and convexity on a weighted average basis, more recent tools integrated Value at Risk (VaR) concepts into ALM with reports like Earnings at risk, cost to close and Capital at risk reports.
In this study note we will look primarily at interest rate risk (in particular interest rate mismatch risk) and liquidity risk.
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: risk arising from timing difference in the maturity and re-pricing of assets, liabilities and off balance sheet items.
Yield Curve Risk: risk arising from unanticipated shifts in the yield curve indicating a change in the relationship between interest rate of different maturities relating to the same market.
Basis Risk: risk arising 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: risk arising from the seller or holder of an asset, liability or off-balance sheet item having the right to alter the level and timing of its cash flows when interest rates change.
Liquidity risk is the risk of potential loss to an entity due to the non-availability or insufficiency of liquidity. This could mean that the entity fails to meet it financial commitments and obligations because of its inability to convert assets into cash, or because it cannot obtain enough funds at a reasonable cost. Liquidity risk could also arise because of a market disruption or liquidity squeeze which could hamper the entity’s ability to sell off its exposures or to do so at a loss or significant discount.