Selected ALM Issues - International Actuarial Association

36 Pages·2003·1.2 MB·English

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: [phone]
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,
the overriding concern of ALM teams is the
current issues
quality of their information, which must be
exhaustive, accessible and easy to model.
This part of our study examines, in an
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. With fixed-rate loans, the bank uncertainty of the information and the
can anticipate its future flows with liquidity of the security. From a technical
certainty on condition that the payment ~erspective,l iquidity risk management is
dates coincide, which is not always the much less advanced and thus demands a
case. In practice, this is not always the case. considerable amount of common sense as
As a result, the bank relies on cashflow well as theoretical know-how. There are
matching methods, which we will examine three basic requirements: the issuer must
in section 11.3. With a variable-rate loan, make an accurate assessment of its cash
the flows are not always known in advance requirements; it must be present in
(unless the lender uses a highly accurate numerous markets, including foreign ones;
matching method). However, if we look at and it must operate a financial PR policy
fair market values, i.e. the value of the that minimises the "risk premium".
credit flows discounted at market rates, we
observe that variable-rate loans vary less We need to paint a broader picture of the
than fixed-rate ones. As regards income economic risks affecting banks, even
flows and their economic value, everything though the process of measuring and
depends on the geometry of the flows and controlling such risks is not always an
on market conditions. In Part 111, we integral part of ALM. Clearly, the oldest
discuss and model the process of taking
and most significant form of exposure is note that the decision involves operational
credit risk. Even though it differs from the factors that do not come within the
risks described above, it is clearly related to bailiwick of the finance department, even
interest rate risk. First, as regards variable- though that department will assess the
rate loans, a rise in interest rates can force a broad economic interest. A more proactive
borrower to default. And because it strategy may consist in designing new
eliminates expected income flows, default products. For example, when the yield
can create market risk and thus interfere curve is steeply sloped, it offers the
with the management of interest rate risk. opportunity of selling capped variable-rate
Other risks that warrant consideration loans to a certain segment of the customer
include the behaviour of a bank's customers base.
in the presence of so-called embedded
options, the right to certain types of loan, Responsibility for ALM is generally
the right to withdraw deposits, and the right devolved to two entities: on the one hand, a
of refund. In the case of non-bank department tasked with analysing,
activities, other assets such as equities or preparing and implementing strategy; on
property give rise to risks. And we have not the other hand, a committee comprising
even addressed the need for insurance representatives of general management and
companies to control their liability risks, or the various specialist arms, which is in
operational risks of all sorts. Last but not charge of financial decision-making and, in
least, the practice of analysing competitive certain cases, product development.
pressures should become more widespread. Dealing rooms are entrusted with the task
After all, lending and borrowing margins of putting these decisions into practice;
are core considerations for any merchant, depending on the institution, they either
whether he is distributing or collecting. deal only for their own account or have a
discrete investment banking operation. The
entity in charge of operations can, in
b) Control strategies certain cases, tolerate a degree of latitude,
in the same way that investors will accept a
A bank can react to (or pre-empt) a given tracking error from a fund manager who
situation in many different ways. It manages their money by means of a
generally falls to the finance department of benchmark. Taken to its extreme, ALM can
a bank or financial mstitution to draw up be a profit centre with a delegation of
and implement suitable strategies. market risk.
Some of those strategies are purely All this comes at a cost in terms of
financial, such as the decision to rely on expertise and information technology, not
maturity transformation. Similarly, to mention a slew of procedures that limit
selecting the percentage of equities in an the flexibility of an institution's
insurance company's portfolio involves the departments. But is obviously vital in a
same type of decision. Other strategies give competitive world where, for private
greater emphasis to the distribution side. companies, unearned income is a thing of
For example, in the case of leasing the past. ALM teams, like the practitioners
transactions, if the "tax advantage market" of any other applied discipline, must strike
is prepared to offer higher margins on a the right note of compromise in their
durable basis, having taken into account the analyses (given the cost of obtaining
cost of funds, then it may be worth the exhaustive information). Likewise, their
bank's while to develop this activity. We
recommendations must be easily 12). The actuaries conferences organised
understood throughout the company and by the AFIR show the extent to which the
have a reasonable chance of success. pension industry is becoming increasingly
aware of the importance of ALM.
1.2 Background Much of the credit for spreading the word
about ALM lies with the Association
So recent is the technique of ALM that the Franqaise des Gestionnaires Actif Passif
word "history" seems inappropriate. (AFGAP), founded in 1989 by CCF,
However, its roots can be found in the Compagnie Bancaire and a handful of other
practice of planning and matching pioneers. Today, AFGAP has one 120
cashflows, commonly found in project members, two-thirds of whom are drawn
financing and long employed by specialised from the banking industry, one-fifth from
financial institutions. insurance companies and the remainder
from businesses and consultancies.
The approach was formalised by the British AFGAP's contacts with its counterparts
and, more particularly the American abroad show that France and the UK are
financial world. In terms of risk modelling, probably among the most advanced nations
it dates back to the early 1980s and the in terms of ALM for banking applications.
introduction of measures such as duration However, such is the banking culture in
and cashflow volatility. In terms of countries like the Netherlands and
corporate management, too, it can be found Switzerland that institutions in those
in the concept of decentralised banking, countries have already adopted approaches
which is diametrically opposed to one-stop, based on assetlliability management, albeit
universal banking. In France, ALM first under a different name. Several of the
appeared in the late 1980s and, as we topics covered in this issue of Quants have
recalled in the introduction, was originally already been discussed at AFGAP
developed by medium-sized private banks meetings.
before spreading to the rest of the economy.
Interestingly, the advance of ALM was not
prompted by regulatory constraints. Life 1.3 Methods
insurance companies tried to adapt the
concept, but ran into several difficulties. Strictly speaking, there is no economic or
The most significant hurdle is the financial theory of assetlliability
accounting "maze" specific to the insurance management. Having subsumed a number
industry. The second is the fact that of complementary methods, ALM can be
insurance-company assets and liabilities are likened to a box of tools used by
diversified and non-fungible, meaning that practitioners of the art. For a more detailed
they cannot naturally be represented as description of these methods, see J. Bessis
flows, as they can in the banking world. (1995) and M. Dubemet (1996). We intend
The third problem - without wishing to be to examine the three main approaches: gap
overly polemical - is the relevance of ALM analysis, duration analysis and simulations.
in state-run companies. Recently,
retirement funds, private pension funds and The first method, gap analysis, is widely
employee benefit organisations - often used. It consists in taking the present
acting at the behest of consultants - have balance sheet situation and projecting two
looked into ALM with a view to using it for factors into the future: one the one hand,
strategic asset allocation (see Quants No. the capital flows received or paid out; on
the other hand, the interest received or paid. consideration the uncertainty related to
The diagram of the differences for the equities, which, while offering higher
different maturities is called the treasury yields than bonds, are nevertheless more
gap. Products are usually pooled into volatile.
categories that are as homogenous as
possible, with ranges of dates that are as
detailed as necessary. The analysis then 1.4 Current issues
seeks to update future financing or
investment requirements. The gap can be Aside from the operational management
narrowed by means of transactions in the aspects, which are not addressed in this
"physical" market (issuance, investment). study, there are a several questions of
And although interest rate risk can be principle which, in our view, tend to
eliminated by the use of derivatives, exercise users of ALM techniques.
liquidity risk may persist if gap analysis
reveals a borrowing requirement. First and foremost is the question of capital
allocation, which will be discussed in Part
Second, duration analysis aims to identify 111. Another key issue, covered in Part IV,
the impact of a change in market conditions is the selection of the proportion of equities
- chiefly the term structure of interest rates that insurance companies should hold in
- on several items on the balance sheet or their investment portfolios. But there are
the P&L account. Consequently, it forms an many other questions: the correlation (or
excellent fit with the first method. lack thereof) between accounting data and
However, it is often considered to be economic information, transfer pricing (i.e.
"theoretical", either because it has not yet how to represent the cost of banks' raw
been properly adapted to actual material), the use of derivatives by
requirements, or because it constitutes an insurance companies and pension funds,
"economic" viewpoint that has no direct and the links with credit risk and with the
consequences in accounting terms. At least, regulatory approach to market risk. Then
not in the immediate future.. . there are time-honoured issues such as the
modelling of demand deposits, which will
The third method, simulation, is rapidly become increasingly important - at least for
becoming the only tool that allows the French banks - in the context of the euro.
future to be introduced into factors that are
either internal (e.g. production) or market- Before tackling the two main issues, and at
related (interest rate movements). Initially the risk of over-simplification, we thought
deterministic and scenario-based, it would be useful to examine the subject
simulations rely increasingly on stochastic most traditionally associated with ALM,
modelling- of environment variables. This namely interest rate risk. We have
involves generating a large number of approached it from a practical angle that
random samplings in order to quantify the makes it possible to identify the attractions
probability distribution of a result or an and risks of maturity transformation.
accounting (or financial) quantity at a Moreover, the current slope of the yield
certain horizon. This approach is widely curve (with a gap of more than 3% in early
used by consultants as a basis for the asset October between money market rates and
allocation recommendations they make to 10-yr zero coupon yields) makes this topic
pension funds or insurance companies. It all the more relevant.
allows the user to take into objective
11. Riding the yield curve three months hence. Conversely, if he buys
a I-yr CD, he does not know the price at
Riding the yield curve is a strategy that which he can sell it when the six months
enables an investor to earn a higher rate of are up and he is therefore exposed to the
return by buying longer-dated bills and risk of capital gainlloss.
selling them before they mature. The
attraction of maturity transformation is that Riding the yield curve is a strategy that
yield curves are generally upward- consists in buying paper with a maturity
sloping: there is a yield "premium" for longer than the investment horizon. The
longer-dated investments. If interest rate aim to realise an "extra" return vis-a-vis an
conditions remain unchanged, or if they are investment with a maturity coinciding with
sufficiently stable, an investor may find it his holding period. The investor must take
more profitable to choose a maturity that into consideration not only the upward
exceeds his holding period. By riding the slope of the current yield curve for the
yield curve, investors get a higher starting maturities in question, but also the expected
rate and a capital gain when they sell their level of interest rates when the position is
investment.. .on condition that interest rates closed out.
have not risen in the meantime.
The aim of this part of our study is analyse a) Example
the returns and risks associated with
maturity transformation from the viewpoint The data used in this example are those for
of a corporate treasurer assessing his results 1 October 1996. The treasurer buys a 4-yr
on the basis of market value. We first bond with a par value of FF1,000. Interest
compute the rate of return, the risks and the is paid annually at a rate of 5%. Given the
Shape ratio of this well-known strategy slope of the yield curve, the price paid for
using the term structure of French interest the bond is:
rates at the beginning of October. We then
consider the impact of leverage and
examine how the "persistence" of the yield
curve affects results. We conclude with a
short, empirical test to examine the efficacy
of the strategy in the past.
Consider the situation one year later, when
he receives his first FF50 coupon. We
assume that there has been no change in the
11.1 Defining and analysing the
yield curve. Our treasurer then decides to
strategy
liquidate his position, which he does at the
When an investor's maturity differs from following price:
his horizon, he is exposed to two types of
risk: reinvestment andor capital gain and
loss.
Consider the example of treasurer who has He has therefore received: 1012.52 + 50 =
a certain sum at his disposal for 6 months. FF1062.52. Reasoning in terms of the
If he buys a 3-month CD, he runs a return over one year, it is as though he
reinvestment risk because he does not know invested FF1001.82 for a year at a rate
the rate at which he will invest his funds equivalent to (1062.52-1001.82)11001.82 =
6.06%. Over the same period, a one-year
investment would have returned just
3.82%: our treasurer has made a profit out
of his ride.
The calculation is based on the assumption
that future interest rates are unchanged. If
rates had risen, then the investment would
have returned less than 6.06% and could
even have fallen below the one-year rate. In
this case, a riding strategy would have
resulted in a loss.
Reciprocally, the steeper the curve's
Figure 11.1 : Yields and holding periods
upward slope at the outset, the lower the
interest rates when the position is
liquidated (the horizon), and the higher the From this, we work out the explicit formula
return to the strategy. that gives us the payoff:
MIH
b) Computing the return to the R,=(I+R,)x--I::[-]' -- -1. (11.2)
strategy
Generally speaking, we consider an Observing that the returns are small relative
investor who has a certain sum for a period to 1, we can write a linear formula that
H. He could invest it immediately at the approximates Rg:
spot rate spot RH over this period.
However, he makes forecasts concerning M-H
R(H,M), the rate of maturity M -H that R, = R, +(R, -R,)- H ' (11.3)
will prevail at date H. He thus anticipates
that the rate will be R, , which is low 1. This is valid for money market rates and
actuarial rates.
So he decides to invest in an instrument
with maturity M, greater than H. At H, his
expectation proves to be correct so he c) The future yield curve and the ride
closes out his position, selling his security strategy
for the residual period at the price
prevailing in the market at H. Assuming To make formula (11.3) more meaningful,
actuarial rates (see also Figure I1.1), the we can draw the yield curve that would
return on this transaction over the period H, result in a preset return curve at the end of
noted Rp verifies: the year. Using Equation (II.3), we express
the future rate as a function of the return:
R, = RM+ (R, - R' ) - (11.4)
M-H'
I o as in anticipate
gas in gain