CHAPTER-II

REVIEW OF LITERATURE

ARTICLES OF ASSETS AND LIABILITY MANAGEMENT

Review 1:
Topic: Integrating Asset and Liability Risk Management with portfolio optimization for
individual investors
Author: Travis L .Jones, Ph. D*

A majority of private client practitioners rely on mean-variation optimization (MVO),rules

of thumb ,or model portfolios for making asset allocation recommendations considerations for
income levels and other constraints figure into the typical approach .However not enough
attention is given to the nature of an investors multiple time horizons and implications for cash
flows. These are the future demand placed upon the portfolio. The risk that these demand will
not be met need to be clearly understood in order to validate any asset allocation decision .This
study present an approach of incorporating MVO with in a multi . horizon ,asset-liability
management risk model .This approach allows for cash flow matching of a portion of an
investors portfolio with in the optimization framework .This allows are individuals portfolio to
provide short- term cash flow as needed while also considering the longer term demands on the
portfolio.
Review 2:
Topic : Linking profit to asset liability management of domestic & foreign banks in the U.K
Author : Kyriaki kosmidou ,fotios pasiouras and Jordan Fbro poulos.
The paper employs the statistical cost accounting method on a sample of 36 domestic
and 44 foreign banks operating in the UK over the period 1996.2002 to examine the relationship
between profits and asset liability composition .the sample was initially split into high and low
profit banks by comparing their operating profit with the industry average .the results show that
high profit bank experience consideration lower cost of liability for most source of funding
.which can cover any losses from most the lower rate of return on assets that the experience
compared to their lower profit competitors .the sample was then split into domestic and foreign
banks .the operating profit that domestic banks experience appeared to be generated by the loan
that they hold on their earning assets portfolio and their fixed assets while the operating profit of
foreign banks was generated by all the assets that compare their portfolio .turning to liability
in ,both cases customer and short term funding was to be more costing than other source of
funding.
Review 3:
Topic :A method for strategic asset liability management with an application to the Federal
Home Loans Bank of New York.
Author: S. Seshadri A.Khanna,,F.Harche

Strategic asset liability management is a primary concern in todays banking

environment .In this papers ,we present a methodology to assist in the process of asset liability
selection in a stochastic interest rate environment ,In over approach a quadratic optimizer is
embedded in a simulation model and used to generate patterns of dividends, market value and
duration of capital ,for randomly generate interest rate scenarios. This approach
can be used to formulate ,test, and refine asset liability strategies .we present results of applying
this methodology to data from the Federal Home Loan Bank of
New York.
Review 4:
Topic: Derivatives and pension fund asset-liability management
Author: Meije smink
Department of finance
Erasmus university/ national science foundation(NWO)
Financial derivatives can substantially alter the risk and return profile of investment portfolios.
However modeling the merits of derivatives and financial calculations involving the future
performance of derivatives can be easily misleading. Arbitrage free raising techniques are
required to avoid exploitation of the scenario structure underlying the performance evaluation.
Further, for strategic asset allocation decisions compatibility with long term historical data is
desirable. Since risk neutral pricing models eliminate asset risk premiums they do not represent
expected developments correctly. Therefore, we should add back the risk premiums in a way that
is consistent with the models. In this article we consider the role of derivatives for pension fund
asset-liability management. Using a simulation approach that integrates a term structure model
with an economic model, we consider the possibilities for pension fund risk reduction with
derivatives.
Here we define risk in terms of the down side volatility of the asset to liability funding ratio. We
show that derivatives can indeed substantially reduce funding risk but thet the relative
attractiveness of derivatives strongly depends on the regulatory treatment.
Review 5 :
Topic : asset-liability managemenet Tektas in financial crisis
Author : Tektas arzu, ozkan gunay, E.nur; gunay,gokhan,

Purpose and efficient asset-liability management requires maximizing banks profit as well as
controlling and lowering various risk. These multi objective decision problem aims to reach
goals such as maximization of liquidity ,revenue ,capital adequacy, and marketing share subject
to financial, legal requirements and institutional policies. This paper models asset-liability
management(ALM) in order to show how different managerial strategies effect the financial
wellbeing of banks during crisis.
Design / methodology/approach- a goal programming model is developed and applied to two
medium scale Turkish commercial banks with distinct risk-taking behavior. This article beings
new evidence on the performance of emerging market banks with different managerial
philosophies by comparing asset-liability management in crisis.
Findings- the study as shown how shifts in markets perceptions can create trouble during crisis,
even if objective conditions have not charged. Originality/value-the proposed model can provide
optimal forecasts of asset-liability components and banks financial standing for different risktaking strategies under various economic scenarios. These may facilitate the preparation of
contingency plans and create a competitive advantage for bank decision makers.

THEORETICAL CONCEPT
ASSET&LIABILITY MANAGEMENT (ALM)

SYSTEM:

Introduction:

In the normal course, the is exposed to credit and market risks in view of the asset liability transformation. With
the liberalization in the

Indian financial markets over the last few years and growing integration of
domestic markets and with external markets the risks associated with operations
have become complex, large, requiring stragic management. are now operating in
a fairly deregulated environment and are required to determine on their own,
interest rates on deposits and advance in both domestic and foreign currencies on a
dynamic basis. The interest rates on

investments in government and other

securities are also now market related. Intense competition for business involving
both the assets and liabilities, together with increasing volatility in the domestic
interest rates, has brought pressure on the management of to maintain a good
balance among spreads, profitability and long-term viability. Impudent liquidity
management can put earnings and reputation at great risk. These pressures call for
structured

and

comprehensive

measures

and

not

just

adios

action.

The

management of has to base their business decisions on a dynamic and integrated

risk management system and process, driven by corporate strategy. are exposed to
several major risks in course of their

business-credit risk, interest rate and

operational risk therefore important than s introduce effective risk management

systems that address the issues related to interest rate, currency and liquidity risks.

need to address these risks in a structured manner by upgrading their risk management and adopting more
comprehensive Asset-Liability management (ALM) practices than has been done hitherto. ALM among other
functions, is also concerned with risk management and provides a comprehensive and dynamic framework for
measuring, monitoring and managing liquidity interest rate, foreign exchange and equity and commodity price
risk of a that needs to be closely integrated with the business strategy. It involves assement of various types
of risks altering the asset liability portfolio in a dynamic way in order to manage risks.

The initial focus of the ALM function would be to enforce the risk
management discipline, viz., and managing business after assessing the risks
involved.

In addition, the managing the spread and riskiness, the ALM function is more
appropriately viewed as an integrated approach which requires simultaneous
decisions about asset/liability mix and maturity structure.

RISK MANAGEMENT IN ALM:

Risk management is a dynamic process, which needs constant focus and attention. The idea of risk
management is a well-known investment principle that the largest potential returns are associated with the
riskiest ventures. There can be no single prescription for all times, decisions have to be reversed at short
notice. Risk, which is often used to mean uncertainty, creates both opportunities and problems for business and
individuals in nearly every walk of life.

Risk sometimes is consciously analyzed and managed; other times risk is simply ignored, perhaps out of lack of
knowledge of its consequences. If loss regarding risk is certain to occur, it may be planned for in advance and
treated as to definite, known expense. Businesses and individuals may try to avoid risk of loss as much as
possible or reduce its negative consequences.

Several types of risks that affect individuals and businesses were introduced,
together with ways to measure the amount of risk.
The process used to systematically manage risk exposure is known as RISK
MANAGEMENT. Whether the concern is with a business or an individual situation,
the same general steps can be used to systematically analyze and deal with risk.

Steps in Risk management:

Risk identification
Risk evaluation
Risk management technique

 Risk measurement
Risk review decisions

Integrated or enterprise risk management is an emerging view that recognizes

the importance of risk, regardless of its source, in affecting a firms ability to realize
its strategic objectives. The detailed risk management process is as follows;

Risk identification:

The first step in the risk management process is to identify relevant

exposures to risk. This step is important not only for traditional risk management,
which focuses on uncertainty of risks, but also for enterprise risk management,
where much of the focus is on identifying the firms exposures from a variety of
sources, including operational, financial, and strategic activities.

Risk evaluation:

For each source of risk that is identified, an evaluation should

be performed. At this stage, uncertainty of risks can be categorized
as to how often associated losses are likely to occur.
In addition to this evaluation of loss frequency, an analysis of
the size, or severity, of the loss is helpful. Consideration should be
given both to the most probable size of any losses that may occur
and to the maximum possible losses that might happen.

Risk management techniques:

The results of the analyses in second step are used as the basis for decisions
regarding ways to handle existing risks. In some situations, the best plan may be to
do nothing. In other cases, sophisticated ways to finance potential losses may be
arranged. The available techniques for managing risks are GAP Analysis, VAR
Analysis, Heinrich Domino theory etc., with consideration of when each technique is
appropriate.

Risk measurement:
Once risk sources have been identified it is often helpful to measure the
extent of the risk that exists. As pert of the overall risk evaluation, in
some situations it may be possible to measure the degree of risk in a
meaningful way. In other cases, especially those involving individuals
computation of the degree of risk may not yield helpful information
.

Risk review decisions:

Following a decision about the optimal methods for handling identified risks, the business or individual must
implement the techniques selected. However, risk management should be an ongoing process in which prior
decisions are reviewed regularly. Sometimes new risk exposures arise or significant changes in expected loss
frequency or severity occur. The dynamic nature of many risks requires a continual scrutiny of past analysis
and decisions.

DIMENSIONS OF RISK

Specifically two broad categories of risk are the basis for classifying financial
services risk.
(1)Product market Risk.

(2)Capital market Risk.

Economists

have

long

classified

management

problems

as

relating to either The Product Markets Risks or The Capital Markets

Risks.

TOTAL FINANCIAL SERVICES FIRMS RISK.

Total Risk
(Responsibility of CEO)

Business Risk

Product Market Risk

(Responsibility of the

Financial Risk

Capital Market Risk

(Responsibility of the

Chief Operating Officer)

Chief Financial Officer)

Credit

Interest rate

Strategic

Liquidity

Regulatory

currency

Operating

Settlement

Human resources

Basis

Legal

(I).PRODUCT MARKET RISK:

This risk decision relate to the operating revenues and expenses of the form
that impact the operating position of the profit and loss statements which include
crisis,

marketing,

operating

systems,

labor

cost,

technology,

channels

of

distributions at strategic focus. Product Risks relate to variations in the operating

cash flows of the firm, which affect Capital Market, required Rates Of Return;

(1) CREDIT RISK

(2) STRATEGIC RISK

(3) COMMODITY RISK

(4) OPERATIVE RISK

(5) HUMAN RESOURCES RISK

(6) LEGAL RISK

Risk in Product Market relate to the operational and strategic aspects of managing
operating revenues and expenses. The above types of Product Risks are explained as follows.

(1).CREDIT RISK:

The most basic of all Product Market Risk

or other financial intermediary is the

erosion of value due to simple default or non-payment

by the borrower. Credit risk

has been around for centuries and is thought by many to be the dominant financial
services today. Intermediate the risk appetite of lenders and essential riskyness of
borrowers.

Manage this risk by ; (A) making intelligent lending decisions so that

expected risk of borrowers is both accurately assessed and priced; (B) Diversifying
across borrowers so that credit losses are not concentrated in time; (C) purchasing
third party guarantees so that default risk is entirely or partially shifted away from
lenders.

(2). STRATEGIC RISK:

This is the risk that entire lines of business may succumb to competition or
obsolescence. In the language of strategic planner, commercial paper is a substitute
product for large corporate loans. Strategic risk occurs when is not ready or able to
compete in a newly developing line of business. Early entrants enjoyed a unique
advantage over newer entrants. The seemingly conservative act of waiting for the
market to develop posed a risk in itself. Business risk accrues from jumping into
lines of business but also from staying out too long.

(3). COMMODITY RISK:

Commodity prices affect and other lenders in complex and often unpredictable ways. The
macro effect of energy price increases on inflation also contributed to a rise in interest rates,
which adversely affected the value of many fixed rate financial assets. The subsequent crash in
oil prices sent the process in reverse with nearly equally devastating effects.

(4). OPERATING RISK:

Machine-based system offer essential competitive advantage in reducing

costs and improving quality while expanding service and speed. No element of
management process has more potential for surprise than systems malfunctions.
Complex, machine-based systems produce what is known as the black box
effect. The inner working of system can become opaque to their users. Because
developers do not use the system and users often have not constitutes a significant
Product Market Risk. No financial service firm can small management challenge in
the modern financial services company.

(5). HUMAN RESOURCES RISK:

Few risks are more complex and difficult to measure than those of personnel
policy; they are Recruitment, Training, Motivation and Retention. Risk to the value of
the Non-Financial Assets as represented by the work force represents a much more
subtle of risk. Concurrent with the loss of key personal is the risk of inadequate or
misplaced motivation among management personal. This human redundancy is
conceptually equivalent to safety redundancy in operating systems. It is not
inexpensive, but it may well be cheaper than the risk of loss. The risk and rewards
of increased attention to the human resources dimension of management are
immense.

(6). LEGAL RISK:

This is the risk that the legal system will expropriate value from the
shareholders of financial services firms. The legal landscape today is full
of risks that were simply unimaginable even a few years ago. More over
these risks are very hard to anticipate because they are often unrelated to
prior events which are difficult and impossible to designate but the
management of a financial services firm today must have these risks at
least in view. They can cost millions.

(II). CAPITAL MARKET RISK:

In the Capital Market Risk decision relate to the financing and financial support of
Product Market activities. The result of product market decisions must be compared to the
required rate of return that results from capital market decision to determine if management is
creating value. Capital market decisions affect the risk tolerance of product market decisions
related to variations in value associated with different financial instruments and required rate of
return in the economy.

1. LIQUIDITY RISK
2. INTEREST RATE RISK
3. CURRENCY RISK
4. SETTLEMENT RISK
5. BASIS RISK
1. LIQUIDITY RISK:

For experienced financial services professionals, the foremost capital market

risk is that of inadequate liquidity to meet financial obligations. The obvious form is
an inability to pay desired withdrawals. Depositors react desperately to the mere
prospect of this situation.

They can drive a financial intermediary to collapse by withdrawing funds at a rate

that exceeds its capacity to pay. For most of this century, individual depositors who
lost faith in ability to repay them caused failures from liquidity. Funds are deposited
primarily as a financial of rate. Such funds are called purchased money or
headset funds

as they are frequently bought by employees who work on the

money desk quoting rates to institutions that shop for the highest return. To check
liquidity risk, firms must keep the maturity profile of the liabilities compatible with
that of the assets. This balance must be close enough that a reasonable shift in
interest rates across the yield curve does not threaten the safety and soundness of
the entire firm.

2. INTEREST RATE RISK:

In extreme conditions, Interest Rate fluctuations can create a liquidity crisis. The
fluctuation in the prices of financial assets due to changes in interest rates can be
large enough to make default risk a major threat to a financial services firms
viability. Theres a function of both the magnitude of change in the rate and the
maturity of the asset. This inadequacy of assessment and consequent mispricing of
assets, combined with an accounting system that did not record unrecognized gains
and losses in asset values, created a financial crisis. Risk based capital rules
pertaining to have done little to mitigate the interest rate risk management
problem. The decision to pass it of, however is not without large cost, so the cost
benefit tradeoff becomes complex.

3.

CURRENCY RISK:

The risk of exchange rate volatility can be described as a form of basis risk
among currencies instead of basis risk among interest rates on different securities.
Balance

sheets

comprised

of

numerous

separate

currencies

contain

large

camouflaged risks through financial reporting systems that do not require assets to
be marked to market. Exchange rate risk affects both the Product Markets and The
Capital Markets. Ways to contain currency risk have developed in todays derivative
market through the use of swaps and forward contracts. Thus, this risk is
manageable only after the most sophisticated and modern risk management
technique is employed

4.SETTLEMENT RISK:

Settlement Risk is a particular form of default risk, which involves the

competitors. Amounts settle obligations having to do with money transfer, check
clearing, loan disbursement and repayment, and all other inter- transfers within the

worldwide monetary system. A single payment is made at the end of the day
instead of multiple payments for individual transactions.

5.BASIS RISK :

Basis risk is a variation on the interest rate risk theme, yet it creates risks that are less
easy to observe and understand. To guard against interest rate risk, somewhat non comparable
securities may be used as a hedge. However, the success of this hedging depends on a steady and
predictable relationship between the two no identical securities. Basis can negate the hedge
partially or entirely, which vastly increases the Capital Market Risk exposure of the firm.