Financial Risk

Management
By S.CLEMENT
 What we anticipate seldom occurs;
what we least expect generally
happens.
Benjamin Disraeli 1804-1881, British
prime minister and novelist
Only certain thing is Uncertainty
Change is the only permnant
So risk management is an option
or compulsion ?
 Risk management means
• The management of the organization's cash
flows, its banking, money market and capital
market transactions; the effective control of the
risks associated with those activities; and the
pursuit of optimum performance consistent
with those risks.”

--- The Chartered Institute of Public

Finance and Accountancy (CIPFA)
 Financial Risk Management

• It is concerned with strategic balance sheet management

involving risk caused by changes/ volatility in the market.
• It is not a choice but compulsion due to Volatility (currency,
commodity & stock market), Product innovation, Regulatory
environment and Management recognition.
• It does not only involve managing the existing balance sheet but
also planning the future size of balance sheet.
• Significant of FRM is further highlighted by recent turmoil in
global market and failure of super heroes.
 Failure of super Heros
• Oct,1907 –a run on the Knickerbocker trust after it failed to
corner the market in United copper shares caused panic on Wall
street . Stocks plummeted , threatening major banks with failure.
Calming influence came not from Fed (which did not exist) but
from JP Morgan Who organized a consortium of banks to provide
liquidity support to prop up banks and buy up stocks.
• 1930, Great depression – 9000 banks failed after stock market
collapse , massive loan failure and runs by depositors to with draw
deposits. President Roosevelt declared bank holiday for 3 days.
Passing of Glass-Steagall Act 1933 and also FDIC to restore
public confidence.
• 1972- failure of Commonwealth bank in Detroit city. FDIC
provided $36 mn in loans – never to be repaid.
• June,1974 – failure of Herstatt bank in Germany.
 Failure of super Heros
• 1980,First Pennsylvanina – established in 1972
as one of the first US private banks. Made
insolvent due to high deposit rates that
outstripped lower yield on assets. It was large
scale bailout by FDIC.
• 1984, continental Illinois – one of 7th largest US
banks and was deemed too big to( $ 40 billion
asset) fail. But failed due to bad oil and Gas
exploration.
• 2003, GTB – failure in India due to excessive
stock market exposure, inadequate provision for
NPA and Fudging of balance sheet.
 Failure of super Heros
• 2008, Bear Stearns – first victim of Sub prime market crisis. Highly leveraged
balance sheet with a capital base of $12 bn for assets worth $395bn, a leverage
of 1:35. JP Morgan Chase & co agreed to buy at a rock bottom price of $10 per
share with Fed agreeing to guarantee $29 bn in Bear Stearns assets taken on by
JP Morgan Chase & co .
• 2008, Lehman Brothers failed and filed for bankruptcy. Another victim of Sub
prime market crisis. Again highly leveraged balance sheet. capital ($25bn) to
asset ($600 bn).
• 2008, Merrill Lynch was taken over by BOA.
• 2008, Northern Rock , UK.- Nationalized.
• 2008,Fannie Mae & Freddie Mac- Government seized the control.
• 2008,AIG group- Fed steeped in to rescue with of $85bn package.
• 2008,Washington Mutual Fund (WAMU) since merged with JP Morgan.
• 2008, CITI Bank – bailed out by US Government by funds infusion
• 2010 – European crisis
• Why this should happen ?
• Any guess ?
• What is the common trait in all these failures?
 B/S of a Bank
• LIABILITIES • ASSETS
• Capital I & II • Cash on hand
• Free reserves • Cash with RBI
• Fixed assets
• Borrowings- ST/LT
• Investments –ST/LT
• Deposits • Loans & Advances
• CD/SB – ST • CC/OD/DL/Bills -ST
• TD – LT • T/L - LT
• CL & Provisions • Current Assets
• IA- Losses /VRS etc
 Balance sheet management functions
• Asset side management include –
• Reserves position management
• Liquidity management
• Treasury management
• Loan management
• Fixed assets management
• Liability side management includes –
• Capital management
• Deposits management
• Borrowings management
 Current Issues
• Present size of of B/S
• Targeted size of B/S
• Integrated view of balance sheet
• Targeted profit
• Volatility – currency/commodity/stock
market + sub prime crisis = RISK
 Risk management
• Risk is probability of loss
• Risk is the probability that the realized
return would be different from the
anticipated/expected return on asset
• Risk is a measure of likelihood of a bad
financial outcome.
• Risk is the uncertainty of future cash flows
or earnings
 Total risk =
Systemic + Non systemic
• Systemic risk • Non Systemic risk
• Portion of Risk which • Stems from Firm-
attributable to Specific Factors,
Economic Wide referred to as lock
Factors such as market out , strike, fire etc. It
conditions. E.g. Oil is Bank specific .E.g.
price/ interest /sub ICICI bank exposure
prime market crisis to Lehman brothers
• It is market related and
affects one and all.
 Why FRM ?
• Deregulation / Globalization
• Frequent changes in SLR / CRR
• Free pricing of loans / deposits
• Market determined exchange rates - free & volatile
• New financial instruments – CP/COD/T.bill /ECB /ADR
• More players- new generation pvt./foreign banks /NBFCs/MFIs
• Insurance sector – before 2000 it was 5 players and now it is > 47
players.
• MF sector – before 2000, hardly a few players. Now?
• Increased cross border inflows. Financial > Trade flows
• Increased regulatory glare/focus
• Consistent volatility – commodity/currency/stock market
• Impact of BASEL III/ Insurance II
• Now FSDC
 What is the greatest risk?

• What you do not know about your risk is

itself is risk
• Not taking risk itself is risk
• So risk management is not an option but
compulsion
 Types of risks
• Credit Risk – failure to perform as per agreed
terms. E.g. Default, delayed payment, failure to
create to charge on collaterals,
• Market Risk – adverse movement in rates.
Liquidity, Interest rate, Treasury, Forex,
Commodity.
• Operational Risk - any loss arising due to human
or system failure or external events. E.g.
Regulatory, Fraud, Forgery,Systems failure, Legal
etc.
 Risk management
• ALM is essentially a risk management measure
• Risk cannot be avoided
• Risk management to minimize the loss i.e. risk
appetitie
• Risk management includes –
• Identification – source of risk
• Measurement – quantification
• Mitigation or manage – through risk hedging tools to
minimize loss.
• Monitor – probability of loss and loss tolerance level.
 Objectives of ALM
• Spread management
• Asset quality
• Capital structure
• Off balance sheet items
 Significance
• A bank may have enough assets to pay off its
liabilities.
• But if 50% of the liabilities (E.g. deposits) are
maturing with in one year and 10% of assets
(loans) are maturing with in the same period .
• It may lead to severe liquidity crisis.
• In the mean time interest rates may under go a
change. This will result in volatility in profits.
• Ultimate objective – to protect Net interest income
( Interest earned – Interest paid) + Non interest
income.
 Credit risk
• BASEL II – failure to perform as per agreed terms.It may
be total or partial default in payment or non compliance
of conditions of sanction. Either way it may result in loss
to the bank. E.g. failure to execute documents for the
loan taken.
Credit Risk Management Objectives:
• To evolve a uniform and rational system
• To achieve more objectivity
• To select realistic limits
• To reduce exposure risks within manageable levels
• To develop a model for synthesis of objectivity &
subjectivity
 Risk management
• Objectives of RM - Banking
• 1. To manage net Interest Income
• 2. To Manage Non Interest Income
• 3. To Maximize share holders wealth/ Market
value of equity
• Insurance – Solvency margin/ claims/ capital /
investment etc
 Credit risk Management
• Exposure Risk Adjustment Factor:
• Statutory Prescription
• Bank level Exposure Limit
Industry Specific Cap
Company Specific Cap
Security Specific Cap
 Credit risk Management
• Critical aspects:
• Net Worth
• Credit Rating
• Market Perception
• Value Relationship
 Managing capital
• According to RBI, The banking sector would
require additional capital of Rs 5,68,744 crore in
the next five years.
• Over the next five years public sector banks would
require Rs 3,69,115 crore (64.9 per cent of total
requirements), old private sector banks Rs 23,319
crore (4.1 per cent), new private sector banks Rs
1,13,180 crore (19.9 per cent) and foreign banks
Rs 63,131 crore (11.1 per cent).
 Managing capital
• Since banks are maintaining Tier I capital significantly above the
required level, this requirement is estimated at only Rs 2,33,564
crore during 2007-12, in which case the balance would have to
come from Tier II capital, the report said.
• Tier I capital requirements for the next five years were estimated at
Rs 1,55,569 crore for PSU banks, Rs 8,178 crore for old private
sector banks, Rs 49,278 crore for new private sector banks and Rs
20,540 crore for foreign banks.
• In the case of nationalised banks, in the past five years, the
increase in Tier I capital requirement was largely met by
ploughing back profits, while the increase in Tier II capital
was predominantly through discounted subordinated debt
 Managing capital
• Reserves accounted for 86 per cent of the total Tier I capital in 2006-
07. Therefore, it is likely that in the next five years, these banks would
be able to increase their Tier I capital fund requirements largely
through reserves, the report said.
• Some public sector banks also have sufficient headroom available for
raising equity as the Government shareholding in these banks is
significantly above the minimum requirement of 51 per cent, noted
the Report.
• The total headroom available to nationalised banks was Rs 2,637
crore,
• However, only six of the 20 nationalised banks (including IDBI), have
headroom of over Rs 100 crore each.
 Managing capital
• Indian economy expected to grow @ 9%.. Indian banks should lend
corresponding to the expected growth . For that capital is required.
• For Basel II expected requirement of capital @ 12%. On average , expected
capital infusion every year is RE 1,12,000 crore.

• Options- equity/ perpetual preference shares and bonds/ plough back of profits.
Also revaluation reserve. Government holding level to come down to atleast to
33%. Increase In FDI cap.
• E.g. SBI raised capital through rights issue.
• Obstacle for government banks – regulatory restrictions for government
holding not to drop below 51%.
• Challenge- capital linked to business.
• Strategies ICICI bank raised 50% funds in India and 50% abroad
• AXIS bank raised entire funds in overseas market
 Changing liability structure of banks

End Capital & Deposits Other liab.&

Borrowings
march Reserves Provisions
2003 5.8 79.8 5.1 9.3
2004 5.9 80.0 4.8 9.3
2005 6.4 78.0 7.1 8.5
2006 6.6 77.7 7.3 8.4
2007 6.4 77.9 7.0 8.8
 Changing liability structure of banks
• RBI- Higher reliance on borrowed funds rather than
deposits to finance to finance business poses a threat of
systematic risk.
• Depositors switched alternative investments such as MF,
stocks etc.
• Shift in resource mobilization increases the cost for
banks and also costly management of funding.
• Alternatively , shift also helps to manage cost such as
branch structure
 CAPITAL ADEQUACY RATIO(%) OF BANKS

BANKS 2007-08 2006-07

BANKH OF BARODA 13.91 12.61

BANK OF INDIA 13.01 11.52
CANARA BANK 12.66 12.78
CENTRAL BANK OF INDIA 12.43 12.15
SBI 13.53 12.45
ICICI BANK 10.36 11.78
HDFC BANK 11.66 12.16
AXIS BANK 11.21 12.66
PNB 13.10 14.78
 CAR – ET survey
• More than 79% of banks have more than 8 % as
CAR
• Average CAR works out to 13% for major banks
• CAR has gone up by 0.7% in 07-08.
• Average of 23 privative banks was estimated at
14.3% in 07-08 . CAR for private banks went up by
2.28%
 Management of Liquidity risk
• LM is the process of generating funds to meet
contractual obligations (both at liability and asset
side ) at reasonable prices at all times.
• Contractual obligations include
• New loan demand
• Existing loan commitments
• Deposit withdrawals – premature/maturity
closure
• To fund contingent liabilities - guarantee/ letter
of credit
 LIQUIDITY RISK
• In ability to adjust increase in assets(loans
and investments) and decrease in liabilities
(deposits) I.e inability to meet all demands
for cash – deposit withdrawals & loan
demands.
• Too much or Too little cash
 Liquidity risk
• The sources of liquidity may be from the assets side or the liability
side of the Balance Sheet or more generally, from the maturity
structure of the Balance Sheet.
• Funding – Non renewal or premature closure of liabilities
• Time – Non receipt of expected inflows from loans
• Call - Crystallization of contingent liabilities .
• How to measure ? – Gap analysis based on maturity profile of
asset and liability.
 Maturity Pattern of Select Assets & Liabilities of A Bank
Liability/Assets Rupees In Percentage
(In Cr)

I. Deposits 15200 100

a. Up to 1 year 8000 52.63
b. Over 1 yr to 3 yrs 6700 44.08
c. Over 3 y rs to 5 yrs 230 1.51
d. Over 5 years 270 1.78
II. Borrowings 450 100
a. Up to 1 year 180 40.00
b. Over 1 yr to 3 yrs 00 0.00
c. Over 3 y rs to 5 yrs 150 33.33
d. Over 5 years 120 26.67
III. Loans & Advances 8800 100
a. Up to 1 year 3400 38.64
b. Over 1 yr to 3 yrs 3000 34.09
c. Over 3 y rs to 5 yrs 400 4.55
d. Over 5 years 2000 22.72
Iv. Investment 5800 100
a. Up to 1 year 1300 22.41
b. Over 1 yr to 3 yrs 300 5.17
c. Over 3 y rs to 5 yrs 900 15.52
d. Over 5 years 3300 56.90
 STATEMENT OF
STRUCTURAL LIQUIDITY
• Places all cash inflows and outflows in the maturity
ladder as per residual maturity
• Maturing Liability: cash outflow
• Maturing Assets : Cash Inflow
• Classified in to 8 time buckets
• Mismatches in the first two buckets not to exceed 20%
of outflows
• Shows the structure as of a particular date
• Banks can fix higher tolerance level for other maturity
buckets.
• Now RBI vide circular dated 5.09.07. advised banks to
split first time bucket (1-14 days) in to next day,2-7 and
8-14 days.
Maturity Buckets for measuring LR
ADDRESSING THE MISMATCHES
• Mismatches can be positive or negative

• Positive Mismatch: M.A.>M.L. and Negative

Mismatch M.L.>M.A.

• In case of +ve mismatch, excess liquidity can

be deployed in money market instruments,
creating new assets & investment swaps etc.

• For –ve mismatch,it can be financed from

market borrowings (Call/Term), Bills
rediscounting, Repos & deployment of foreign
currency converted into rupee.
 LIQUIDITY Management

• Cap on call borrowings

• Setting up prudential limits
• Purchased funds vs liquid assets
• Core deposits vs core assets
• Duration of assets & liabilities
 DYNAMIC LIQUIDITY
• Seasonal pattern of deposits
• Potential liquidity needs – new loan
demands,un availed c/c limits, potential
deposit losses, investment obligations,
expected changes in SLR/CRR
 Dynamic Liquidity Statement
A Out flows 1-14 days 15-28day 29-90 days
1.Net increase in loans
2.Net increase in investments –
Approves securities, money market instruments
(other than TB.), Bonds/debentures &others
3.Inter bank obligations
4.Off B/S items – REPOs/ Swaps/Bills discounted
5 Others
Total out flows
B. Inflows
1.Net cash position
2.Net increase in deposits (other than CRR)
3.Interest claims
4. Refinance/inter bank claims/off b/s/inter bank
Claims/others
Inflows
C. Mismatch (B-A)
D Cumulative mismatch
E. C as % of total out flow
 Contingency funding plan
• Liquidity Risk Management:
• Maturity Matching
• Composition of Assets
• Composition of Liabilities
• Borrowing ability
• Assets & Liabilities Management
• Lines of Credit
 Interest Rate Risk Management
• Interest Rate risk is the exposure of a bank’s financial conditions
to adverse movements of interest rates.
• Though this is normal part of banking business, excessive interest
rate risk can pose a significant threat to a bank’s earnings and
capital base.
• Changes in interest rates also affect the underlying value of the
bank’s assets, liabilities and off-balance-sheet item.
• Interest rate cut reduces the yield on G-Sec. E.g. Yield on 6.90%,
2019 G-Sec went as low as 7.22% .
• Effect on balance sheet ?
 Interest Rate Risk

• Interest rate risk refers to volatility in Net

Interest Income (NII) or variations in Net
Interest Margin(NIM).
• Therefore, an effective risk management
process that maintains interest rate risk
within prudent levels is essential to safety
and soundness of the bank.
 Interest Rate Risk (IRR)
Sources:
• Gap risk or Mis match risks– holding assets and
liabilities with different principal amounts, maturity
dates or reprising dates
• E.g. A bank holds Re 100 cr liabilities@ 9% of one
year maturity to fund assets of Re 100 cr @ 10% with 2
year maturity. For the 1st year , interest income is same
giving a spread of 1% (1 cr) . How ever same may not
true if the interest under goes a change and liabilities
are to be renewed at higher interest rates say 11%. It
will result in loss.
• Conversely if assets are for one year and liabilities for 2
years, then also bank will face IRR.
 Interest Rate Risk (IRR)
• Basis risk –
• Interest of two different instruments ( assets and
liabilities) will seldom change in same
proportion or degree during the same period or
time horizon
• The risk that interest rate of different assets and
liabilities may change in different magnitude is
called basis risk.
• E.g. deposit rates go up by 1% and loans by
0.5%.
 Interest Rate Risk (IRR)
• Embedded option risk –
• It may arise due to premature with drawl of
deposits or pre payment of loans
• E.g. a bank has 90 days with a interest rate of
10% loan funded by 90 days fixed deposit with
interest rate of 8%. After 30 days, If interest
rates decline by 1%, borrower prepays loan.
Then NII comes down for anther 60 days.
 Interest Rate Risk (IRR)
• Yield curve risk –
• A yield curve is a line on graph plotting the
yield of all maturities of particular instrument.
• It may arise price fluctuations in securities due
to market conditins
 Interest Rate Risk (IRR)
• Price risk –
• Occurs when assets are sold before their
maturity dates. Bond prices and yields are
inversely related.
• E.g. price of 10 year, 8.40% G Sec( face value
Re 100 and purchased at Re 102) will come
down when securities of similar maturity has
gone up to 9% . Now price may come to Re
100 there by resulting a loss of Re 2 per
security.
 Interest Rate Risk (IRR)
• Reinvestment risk –
• Uncertainty with regard to interest at which
future cash flows can be reinvested is
reinvestment risk.
• E.g. A bank ahs short term bonds with a interest
rate of 5% for 6 months. It is expected to be
reinvested @ 8 % for one year after 6 months. If,
interest rates falls to 7 %, then bank may
reinvestment risk at lower rate of interest.
 Measurement of Interest Rate Risk
• To measure IRR, bank should identify rate sensitive asset and
liability. For this classification bank should forecast interest rate
fluctuations with in forecasting period.
• All assts and liabilities are subjected to repricing with in the planning
horizon are classified as Rate Sensitive Assets (RSA) and Rate
sensitive Liabilities (RSL).
• Repricing means maturing. Question is which is repricing first and at
what cost, considering interest rate scenario ( rising or falling) IRR
highlight the gap which is present between RSA & RSL, maturity
period of the same and resultant gap period. RSG is risk sensitive gap
based on maturity.
• Question which will reprice first , what will be the impact on margins
• RSG = RSA – RSL
• Gap ratio – RSA/RSL
 Risk sensitive assets and liability
• E.g. a bank with interest sensitive assets of Re 60
crore and interest sensitive liabilities of40 croes.
Both fall in a particular maturity bucket.
• If assets reprice first, then it is a positive gap
since assets will reprice at a higher rate of
interest which in turn increase interest income
for the bank. So, it is called positive gap.
• If liability reprice first when interest rise, it will
be negative gap since liabilities to repriced at a
higher rate of interest. It will reduce interest
income.
 Measurement of interest risk – Gap analysis

• Gap Analysis- Simple maturity/re-pricing Schedules can be used to

generate simple indicators of interest rate risk sensitivity of both
earnings and economic value to changing interest rates.
- If a negative gap occurs (RSA<RSL) in given time band, an increase
in market interest rates could cause a decline in Margins i.e. RSL is
maturing first when interest rates are raising. E.g. deposits maturing
first when interest rate is raising.
- conversely, a positive gap (RSA>RSL) in a given time band, an
decrease in market interest rates when RSA maturing first could
cause a decline in NII.
 Measurement of Interest Rate Risk
• First step to measure IRR is gap analysis. Plot all RSL & RSA in
maturity time bucket ( suggested by RBI called as statement of
interest rate sensitivity ) to measure the gap during a particualr
period which can be between 1 month to one year
• Gap Analysis- Simple maturity/re-pricing Schedules can be used to
generate simple indicators of interest rate risk sensitivity of both
earnings and economic value to changing interest rates.
- If a negative gap occurs (RSA<RSL) in given time band, an
increase in market interest rates could cause a decline in NII.
- conversely, a positive gap (RSA>RSL) in a given time band, an
decrease in market interest rates could cause a decline in NII.
 Interest Rate Sensitivity statement
1month 1-3 m 3-6m 6-12m 1-3 yr 3-5 yr >5 yr Non Total
sensitive
A
Liability
B
Asset

C.gap
b-a
+ off
b/s.FRA
etc

D. Total
of others

E.net gap
F. C.gap
G AS %
to B
 MATURITY GAP METHOD
• THREE OPTIONS:
• A) RSA>RSL= Positive Gap ( interest is on
the rise)
• B) RSL>RSA= Negative Gap
• C) RSL=RSA= Zero Gap
 positive Gap

Liability . Rate Increased . Decreased Asset Rate Increased Decreased

% % % %

200
200
800 12 13 11
1800 10 11 9
1000 14 15 13
2000 11 11 11 1000 16 17 15
1000 18 18 18

4000 4000

Int.expense 400 418 382 Int.Income 576 604 548

NII
176 186 166
 Positive gap
• When RSG is positive ,it is implied that the yield earned
in such situation will be more than the rate at which the
liabilities are serviced .
• In the illustration given below, initially cost of funds is
4oo cr, . while yield was 576 cr resulting in NII of 176
cr. Due to repricing of assets first, NII increased to186
from176. It means, there are more repriceable assets than
repriceable liabilities which has resulted in positive gap.

• Risk sensitive asset – 2800

• Risk sensitive liabilities - 1800
• Positive gap - 1000
 Negative gap

Liability . Rate Increased Decreased Asset Rate Increased Decreased

% % % %

200 200

1800 10 11 9 800 12 13 11

2000 11 11 11 1000 14 14 14
1000 16 16 16
1000 18 18 18

4000 4000

Int.expens 400 418 382 Int.Income 576 584 568

NII
176 166 186
 Negative gap
• When RSG is negative gap, repricing
liabilities are more. Interest rate fall/rise
will affect NII.

• Risk sensitive asset – 800

• Risk sensitive liabilities - 1800
• Negative gap - (1000)
 Zero Gap

Liability . Rate Increased . Decreased Asset Rate Increased Decreased

% % % %

200
200
800 12 13 11
1800 10 11 9
1000 14 15 13
2000 11 11 11 1000 16 16 16
1000 18 18 18

4000 4000

Int.expense 400 418 382 Int.Income 576 594 558

NII
176 176 176
 Zero Gap
• Bank can maintain Zero gap, and thus
remain natural to interest rate fluctuations.
• RSA 1800
• RSL 1800
• RSG 0
• No change in NII.
 Strategies
• Utility of maturity gap analysis is that for a
given RSG and with a given forecast of rise and
fall in interest rates, a bank can adopt following
strategies :
• A) maintain positive gap when interest rates are
rising
• B) maintain negative Gap when interest rates
are falling.
• C) Zero gap is rare in reality. It will also reduce
speculative gains.
• D) decide t olerable of change in NII/NIM
Duration Analysis
 Duration analysis
• One of the drawbacks in Gap analysis is that it ignores
time value of money. Attending to this limitation is the
duration gap method.
• Duration analysis concentrates on on the price risk and
reinvestment risk while managing interest rate exposure
.
• While managing two risks, duration studies the effect of
rate fluctuation on the market value of assets and
liabilities and NIM.
• Rate sensitive gap calculated in duration analysis is
concerned with duration of A/L not with maturity of A/l
as in the case of Gap analysis.
 What is Duration ?
• Fundamental Bond theorems state that price of bond is inversely related to
market interest rate.
• If interest goes up price falls and vice versa.
• Bond generates interim cash flows in the form of periodic coupon payments
which reinvested as when received.
• Reinvestment rate depends on market movement in interest rates.
• If interest raises , reinvestment fetches higher returns and vice versa.
• But, there will be capital loss due to fall in the price of bonds and vice versa
• These two opposing effects will neutralize at one point of time or during the life
of fixed income securities at a given interest rate.
• This point of time in life of fixed income security when capital loss/gain is
matched exactly by gain/loss in reinvestment income is called its duration.
• A duration is a direct outcome of interest rate and maturity, it may also may
be defined as price sensitivity measure of a bond to changes in interest rates.
 Duration
• Duration in expressed in years and is
comparable across portfolios.
• Duration of a Zero Coupon Bond is equal to its
maturity.
• Duration of a coupon paying bond / asset is
less than its maturity.
• Longer the maturity of a bond, longer is
Duration.
• Duration is inversely related to Coupon.

66
 Duration
• Duration is directly related to market interest
rates / Yield.
• Higher the frequency of coupons, lower the
Duration.
• Duration of a Floating Rate bond is equal to
its interest reset period or the period
remaining to next reset of interest.
• For small changes in yield, Duration
multiplied by percentage change in yield gives
percentage change in price for bonds.

67
 Duration & Price Change
• If current price of a bond is Rs 98.50, its Duration is
2.7613 and yield is likely to change from 6.00% to
5.80%, then the likely price of the bond is computed
as under:
% change in Price = D*(percentage change in Yield)
= 2.7513 * (6.00 - 5.80)
= 0.55226%
Absolute change in Price = 98.50 * 0.55226%
= 0.54398.
As Yield has come down, price will increase and
therefore, expected bond price will be
Rs 99.04398.

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 Duration & Interest Rate Risk
• If a bank has Asset Duration of 3 years, Assets
of Rs 200 crore and Liabilities (excluding
Equity) of Rs 150 crore, the bank should
target Liability Duration of 4 years
(200*3/150).
• In that case, Duration of Equity will be
(3*200) – (4*150) = 0.
• In other words, bank’s net worth is
immunized against changes in interest rates.

69
Market expectation@ interest at 8%
security issued @ 8% interest
Discount
Rate = 8%
discount Present
year cashflow value Value
1 8 0.9259 7.4074
2 8 0.8573 6.8587
3 8 0.7938 6.3507
4 8 0.7350 5.8802
5 108 0.6806 73.5030
Total 100.0000

M arket P rice is Rs 100 (P ar Value) 70

 Interest Rate
• Suppose that current expectation of yield is
10%. What will be the market price?
Discount
Rate = 10%
discount Present
year cashflow value Value
1 8 0.9091 7.2727
2 8 0.8264 6.6116
3 8 0.7513 6.0105
4 8 0.6830 5.4641
5 108 0.6209 67.0595
Total 92.4184
Market Price is Rs 92.4148 (less than Par
Value) when current expectation of yield has
gone up.

71
 Interest Rate
• Suppose that current expectation of yield is
6%. What will be the market price?
Discount
Rate = 6%
discount Present
year cashflow value Value
1 8 0.9434 7.5472
2 8 0.8900 7.1200
3 8 0.8396 6.7170
4 8 0.7921 6.3367
5 108 0.7473 80.7039
Total 108.4247
Market Price is Rs 108.4247 (more than Par
Value) when current expectation of yield has
come down.

72
 Duration analysis – a case study

• Maturity period of bond 7 years

• Coupon rate 7%
• Face value – Re 100
• What will be price , if the market
expectation is 8% ?
• Note – price of a bond is nothing but the
total of present value of all its future cash
flows.
 Duration analysis – expectation@8%
S.No coupon Disc. PV of coupon Weigh PV X Wt
Factor.8% t in
(Expected) (2X3) years (4 X 5)
1 2 3 4 5 6
1 7 0.9259 6.4813 1 6.4813
2 7 0.8573 6.0011 2 12.0022
3 7 0.7938 5.5566 3 16 .6698
4 7 0.7350 5.1450 4 20.5800
5 7 0.6806 4.7642 5 23.8210
6 7 0.6302 4.4114 6 26.4684
7 107 0.5835 62.4345 7 437.0415
Total PV MP @ 94.7941 543.0642
 Duration
• Duration 543.0642/94.7941 = 5.7288 years.
• How duration help in measuring the price
sensitivity of a bond.
• Alternatively , duration can be measured.
s.no. Coup. Disc. PV PV/total PV Timing of 5X6
Facto@ 8% 2X3 (weight) CF
Col.3 Weight in
e.g. years
6.4813/94.7941

(1) (2) (3) (4) (5) (6) (7)

1 7 0.9259 6.4813 0.068372 1 0.068372

2 7 0.8573 6.0011 0.063307 2 0.126613

3 7 0.7938 5.5566 0.058618 3 0.175853

4 7 0.7350 5.1450 0.054276 4 .217102

5 7 0.6806 4.7642 0.050258 5 0.251292

6 7 0.6302 4.4114 0.046537 6 0.27922

7 107 0.5835 62.4345 0.658633 7 4.610429

Total PV 94.7941 1 Duration 5.728882

 Duration and price change
• Duration X % change in yield
• Suppose if interest falls from from 8.0 to 7.8%
• 5.728882 X (8.0 – 7.80 )
• 1.145774%
• Absolute change in price
• 94.7941 X 1.1457764% = 1.08612as the
interest rate has fallen from 8 to7.8%,price of
the bond will appreciate to 94.7941+ 1.08612 =
95.88022.
 Modified duration
• Normal duration does not capture accurately price changes
in bonds arising from larger changes in interest rates. It can
measure small changes.
• Hence Modified duration.
• MD is a better measure of price sensitivity of bond prices.
• MD = Duration / 1+ Yield.
• As per previous exercise, MD will be
• 5.728882/ (1.08) = 5.3045
• MD ( from 8 to 7.8%) to arrive at price as per MD.
• % of change in price = MD X % of change in yield
• 5.3045 X 0.20 = + 1.0609 %
• Absolute price change =94.7941 X 1.0609%= 1.00567
• New price will be 94.7941 + 1.00567 = 95.79977 ( as
against 95.88022 as per simple duration)
 Duration – To sum up
• Duration is basically a price sensitivity measure.
• Duration is neutral point of time in the life of fixed income
securities when the reinvestment risk is compensated by the
price risk
• Higher the duration, higher will be the price risk to the
holder of a fixed rate bond.
• Duration of coupon paying bond is less than its maturity.
• Duration gap is the difference of assets and liabilities .
• Duration can be positive( Da > Dl), negative (Da < Dl) &
Zero ( Da = Dl).
• Risk averse banks will endeavour to reduce the duration
gap.
• Limitations – does not capture interest rate
volatility/applicable for only small changes/not applicable
for bonds with options.
 Convexity
• Convexity is second order of duration.
• It arises due to the fact – empirical studies
proved that price appreciation for a given
fall in interest is always higher than the
price depreciation when the interest rise by
the same level.
• This property of a bond is due to its
convexity .
• Convexity overcomes the draw back of
duration and modified duration while
measuring price changes beyond 1%.
s.no. Coupon Disc. Factor PV of coupon t(1+t) 4 X 5
@ 8% (2 x 3)

1 2 3 4 5 6

1 7 0.9259 6.4813 2 12.9626

2 7 0.8573 6.0011 6 36.0066

3 7 0.7938 5.5566 12 66.6792

4 7 0.7350 5.1450 20 102.9000

5 7 0.6806 4.7642 30 142.9260

6 7 0.6302 4.4114 42 185.2788

7 107 0.5835 62.4345 56 3496.3320

PV= 94.7941 Total=4043.0852
 Convexity
• Change in price as captured by convexity is obtained by the formula =
0.5 x convexity x (change in yield)2
x 100
• Convexity = 4043.0852 / [ 94.7941 x (1+0.08) 2 ]
= 4043.0852 / 110.5678 =36.56
= change due to MD +Chg. Due to convexity
= (-5.3045 x15) +[0.5 x 36.56 x (0.015 x 100 ]
= 7.95675 + 0.4113
= 7.54545 or – 7.54%
* Thus accurate change in price of the bond when interest rate rises
from 8 to 9.5% is equal to
• 94.7941 x 7.54 /100 = 7.14 i.e. the price of the bond will now be
• 94.7941 – 7.14 = 87.6541
 IRR- Management
• Identification-
• Measurement - Static/Dynamic approach
Maturity buckets to measure the gaps.
• Monitor - Prudential limits
• Manage – reporting and monitoring.
E.g. VAR. ( Value at risk)
 Gap analysis
Non
Amount 1-28 29 >3M- >6M- >1 yr
sensitive
in crores days days 6M 1 yr
to3 M
IRS gap -500 -400 -100 +300 +900 -200
(repricea
ble asset-
RP liab.
Cumulative
gap
-500 -900 -1000 -700 +200
 Risk Management (contd)
• Determine the size of the balance sheet
• Cost/Mix/Yield
• Period
• Policies/Procedure/Structure
• Risk mitigation tools-
Derivatives/Securitisation
 ISSUES
• Int. rates – Fixed(deposits & Floating(loans)
• Regulated int.rate regime- SB/Export
credit/Priority sector advances.
• Lack of MIS
• Global turmoil – liquidity crunch
• Currency fluctuations
• Regulatory intervention – to reduce lending
rates to stimulate growth.
 ALM Mismatch
• Balance sheet of most of the banks reveal short term funding
challenge and this could lead to slow down in lending and also dent
on profits.
• Over the last three 3 years banks have funded long term credit via
short term liabilities mostly deposits a larger part of which is
corporate bulk deposits and certificate of deposits.
• This resulted in AL mismatch i.e. large volume of deposits
maturing faster than the loans.
• Liquid assets ( as a proportion of net NDTL) have come down to
26% from 40% during last 10 years.
• This again resulted in banks operating near SLR minimum of
25%of NDTL. This means banks cannot borrow from RBI via
REPO route against excess of SLR securities to tide over short term
funding needs.
 • AL mismatch as FY 08
Banks Mismatch
in (Re bn)
Karnataka bank -53
Federal bank -89
Ing vysya -58
Yes bank -56
South Indian -13
ICICI -616
PNB -131
SBI - 577
HDFC bank -24
BOB -27
 ALM in INDIA
• RBI guidelines in Feb 10, 99 for covering
60% of business for commercial banks
• From April 2000, 100 % of business
• April 2002- ALM for co operative banks
• ALM – Structure, Policy, Procedure & MIS
• SLS on monthly basis as of last Friday with in
a month from close of last reporting Friday.
 What is store in future?
• BAEL III –
• Solvency II for insurance sector
• CAR – capital adequacy requirement will go up after
implementing BASEL III
• P/A NORMS will be further tightened due to recent failure of
investment banks such Bears Stearns, Leman Brothers etc.
• Volatility – interest rates, exchange rates and commodity
• Consolidation by M & A.
• Competition – RBS secured banking license inJan,2009.
• G 20 compulsions on regulatory aspect.
• Regional imbalances
 SUCCESS OF ALM IN BANKS :
PRE - CONDITIONS
1. Awareness for ALM in the Bank staff at all
levels–supportive Management & dedicated
Teams.
2. Method of reporting data from Branches/ other
Departments. (Strong MIS).
3. Computerization-Full computerization,
networking.
4. Insight into the banking operations, economic
forecasting, computerization, investment,
credit.
5. Linking up ALM to future Risk Management
Strategies.