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Oracle Financial ServicesAnalytics Application-OFSAA Asset Liability Management SATISH KUMAR L CFA 1
ALM in Banking. Master Maintenance Asset liability Management
ALM basically refers to the process by which an institution manages its balance sheet in orderto allow for alternative interest rate and liquidity scenarios. ALM-is a first step in the long-term strategic planning process.-Considered as ALM is Appropriate for institutions planning function for (Banks, finance companies, leasing intermediate term companies, insurance companies, and others) ALM is concerned with strategic Balance sheet management Involving Managing Risk In a sense The various aspects of balance sheet Management of risks caused management deal with by changes in the interest planning, rates, Exchange rates and the Liquidity position of the bank As well as direction and Measure and Monitor control of the levels, changes risk, and provide and mixes of ALM Is approach to Quantify suitable strategies for these risks , that provides assets, liabilities, and capital their management. institutions with protection that makes credit risk, interest risk, and liquidity risk Acceptable. And--------The Role of Securitization--------- 3
The process will involve the following steps: •Firstly, Review the interest rate structure and compare the same to the interest/product pricing of both assets and liabilities. Interest rate. Foreign •Secondly, Examine the loan and the investment portfolios in the light of the foreign exchange/Liqui exchange risk and liquidity risk that might arise. dity risk •Thirdly, examine the probability of the credit risk and contingency risk that may Credit/contingency originate either due to rate fluctuations or otherwise and assess the quality of assets. Risk •Finally, review the actual performance against the projections made and analyze the reasons for any effect on the spreads. Actual performance The ALM technique so designed to manage the various risks will primarily aim to stabilize the short-term profits, long-term earnings and long run sustenance of the bank. *Credit risk: Risk describes the possibility in the repayment obligation by the borrowers of funds (delayed payment also facet of default risk) *Contingent risk :the off-balance sheet items such as guarantees,letter of credit ,underwriting Etc will give rise to the contingent risk. * 4
The enhanced level of importance of ALM has led to the change in the nature ofits functions. Micro-level- Price matching Macro-level- Basically aims to maintain The objective functions of ALM leads to the formulation spreads by ensuring that the the ALM are two-fold. deployment of liabilities will be of at a rate higher than the costs. Critical Business Policies, Efficient allocation of capital It aims at Profitability Example : IRS and through price matching Maturing matching Designing of products with •Similarly, grouping the assets/liabilities appropriate pricing while ensuring liquidity based on their Maturing profiles ensures liquidity. strategies. by means of maturity matching. •The liquidity gap is then assessed to identify the future financing requirements. • Example : Liquidity GAP 5
The most common target accounts in ALM of banks are: •Net Interest Income (NII): The impact of volatility on •The market value the short-term profits is of equity represents •The ratio of the measured by NII. the Long-term shareholders funds profits of the bank. to the total assets •NIM: A performance metric measures the shifts in examines the how successful •The difference the ratio of owned a firms investment decisions between the market funds to total funds. are compared to its Debt value of assets and situations liabilities will be •Stabilizing this the target account. account will generally come as a statutory requirement. Economic NIM/NII MVE EquityNII: The difference between the revenue that is generated from the Banks assets & theexpenses associated with paying out liabilities is NII.NII is more sensitive(Volatile) to thechanges in interest rates.NIM = -VE represents firm did not make an optimal decision =>the firm has los moremoney due to interest expenses than was earned from investments 6
The stress testing frame work included a wide range of Bank-specific and market (Systemic) Played a important scenarios role in :-- Stress testing: It is a key risk management tool during periods of expansion, when innovation leads to new products that grow rapidly and for • Feeding into capital which limited or no loss data is and liquidity planning available(facilitating the development of risk procedures; mitigation) Stress testing is an important risk management tool that is used by banks as part of their internal • informing the setting risk management and, through the Basel II capital of a banks’ risk - adequacy framework. tolerance The Risk Committee also reviews the stress- testing framework as part of the Internal Capital Adequacy Assessment Process (ICAAP). ICAAP :Internal Capital Adequacy Assessment Process (ICAAP).
Asset Liability Management Interest Rate Risk IRR-APPROACHES GAP Analysis . Duration GAP Analysis. Simulation /Sensitivity Analysis. VAR Analysis Managing IRR: Hedging with Liquidity Risk Options, Futures, swaps Exchange Risk
• Interest rate risk arises when the income of the bank is sensitive tothe interest rate fluctuations.•The banks results of operations are substantially dependent upon thelevel of banks net interest margins.• Interest rates are sensitive to many factors to influence the NII &NIM. Including the RBI’S monetary Policies, domestic and internationaleconomic and political conditions and other factors.• Changes in interest rates could affect the interest rates charged oninterest-earning assets and the Interest rates paid on interest-bearingliabilities in different ways 9
For each time bucket the GAP=interest rate sensitive assets (RSAs) --interest rate sensitive liabilities (RSLs). Gap Ratio = RSAs/ RSLs When interest rates change, the bank’s NII changes =>ΔNII = (RSAs - RSLs) x Δr ΔNII = GAP x Δr. A zero GAP will be the best choice either if the bank is unable to speculate interest rates accurately or if its capacity to absorb risk is close to zero. With a zero GAP, the bank is fully protected against both increases and decreases in interest rates as its NII will not change in both cases. This model measures the direction and extent of asset-liability mismatch through a funding or maturity GAP (or, simply, GAP). Assets and liabilities are grouped in this method into time buckets according to maturity.(the maturates are same and then select the gap period , which can be any where between month to a year .* Categorize :RSA &RSL are => requires balance sheet classification based on the rate sensitivity . Based on this banks should first able to forecast interest rate fluctuations .Identify RSA,RSL with in the first forecast period .thus all assets /liabilites are subject to repricing with in the planning horizon are categorize RSA.,RSL’S 10
During a selected gap period, the RSG will be positive when the RSAs are more than the RSLs, negative when the RSLs are in excess of the RSAs, and zero when the RSAs and RSLs are equal. Maintain a positive gap when the interest rates are rising; Maintain a negative gap when the interest rates are on a decline GAP analysis examines the sensitivity of the market value of Financial institutions Net worth(MVE) to change in interest rates . 11
Duration Analysis studies the effect of rate fluctuation on the market value of the assets and liabilities and net interest margins (NIM), with the help of duration. It also provides an approximate measure of market value interest elasticity. Duration analysis begins by computing the individual duration of each asset and liability and weighting the individual durations by the percentage of the asset or liability in the balance sheet to obtain the combined asset and liability duration. DUR gap = DUR assets – K liabilities DUR liabilities Where, K liabilities = Percentage of assets funded by liabilities DGAP directly indicates the effect of interest rate changes on the net worth of the institution. The funding GAP technique matches cash flows by structuring the short-term maturity buckets. 12
How the price of a bond changes in response to the interest rates Duration is defined as the average life of a financial instrument. Duration : A measure of the sensitivity of the price of a fixed income instrument to a change in interest rates . Duration is proportional to the interest rate risk Convexity is a measure of the curvature of how the price of a bond changes as the interest rate changes. Specifically, duration can be formulated as the first derivative of the price function of the bond with respect to the interest rate in question, and the convexity as the second derivative. Duration Analysis : Price risk and the Reinvestment risk The larger the value of the duration, the more sensitive is the price of that asset or liability to changes in interest rates. Bonds with higher durations carry more risk &have higher price volatility . 13
Scenario analysis: static. The sensitivity of an asset/liability can be assessed by the quantum of increase/decrease( Various scenarios) in the value of the assets/liabilities of varying maturities due to the interest rate fluctuations. Various Scenario Analysis :Discrete (continuous) distribution. Example :2%,3%,4%. 14
Simulation models help to introduce a dynamic element in the analysis of interest rate risk. These methods are used to simulate of variety different scenarios (Randomly-Distribution) for the portfolio of Target date Securities commonly used simulation techniques known as Monte Carlo – Methods , to value complex Derivatives and to measure risk . Simulation methods approximates the behavior of financial prices by using computer simulations to generate random price paths . What if scenarios, The absolute level of interest rates shift. There are nonparallel yield curve changes . Marketing plans are under-or-over achieved . Margins achieved in the past are not sustained/improved . Bad debt and prepayment levels change in different interest rate scenarios .(Parallel shift in the yield curve : changes in the yield for all maturities is same).Non –parallel shift in the yield curve ……..> 15
High -Volatility Distribution VAR is the maximum potential loss in market value or income. VAR to be used in combination with Stress Testing Refers to the maximum expected loss that a Possible range of values- Between ‘u’ & sigma bank can suffer over a target horizon, given a certain confidence interval. Low - Volatility Measuring the market risk of a portfolio of Distribution assets and/or liabilities for which no historical data exists.. Calculate the Net worth of the organization at any particular point of time so that it is possible to focus on long-term risk implications of decisions that have already been taken or that are going to be taken. 16
Liquidity risk is the risk of being unable to raisenecessary funds (sufficient cash flows )from the market to meet operational and debt servicing requirements and to capitalize on opportunities for business expansion. Asset Liability Management (ALM) can be defined as a mechanism to address the liquidity risk faced by a Bank due to a mismatch between assets and liabilities either due to liquidity or changes in interest rates.Liquidity is aninstitution’s ability to Approaches :meet its liabilities Fund management ….managing surplus &either by borrowing orconverting assets. Deficit 17
FX- risk is the exposure of an institution to the Adverse fluctuations((unanticipated change) in exchange rates may result in loss in value in terms To the institution Approaches : Transactional exposure(cash flow exposure) :Foreign exchange risk may FX exposure arises from daily foreignarise from a variety of sources currency dealing or trading activates.such as foreign exchangetrading, investments Translational exposure (Accounting Exposure) :denominated in foreign arises form overall asset /liabilitycurrencies and investments inforeign companies, making infrastructure of both on/off Balance sheetsforeign currency loans, buying foreign currency VAR approach to risk associated withsecurities or issuing foreign FX-exposurescurrency -denominated debt,foreign currency retail External approach:accounts and retail cash Forward contractstransactions and services,. Options Swaps ---------Currency gain/loss----- 18
Dimensions-Dimensions are used to arrange(Stratify)business data for processing and Reporting purposes.OFSAA Is Seeded with 6–Key processing Dimensions OU-Dimension Members-Each Dimension comprises of a list of BU-1 BU-2 BU-3 members who share common attributes or characteristic features. Head- count- 32 Attributes-Dimension attribute values are used to qualify dimension members. It provides for defining member characteristics. Curre used extensively in processing ncy 20
Dimensions are used to arrange business data for processing and reporting purposes. The General Ledger (GL) Dimension is used to store all GLs of the bank, in form of its members. GL Accounts used in the Financial Accounting systems of the organization, to store information of Profit and Loss and Balance Sheet items. Organizational Unit dimension stores all Org unit IDs of the bank, with their respective descriptions. An Organizational Unit is used as a segmentation and consolidating Reporting currency to Functional Currency. Financial element dimension stores all Financial Element IDs to be used in the Cash Flow Engine . Financial Element (FE) is used to distinguish business data based on its features. On an event date, OFSA computes the results of that event, the financial elements.
OFSAA supports 3 fundamentally different kinds of dimensionsKey Processing Dimensions: Are accessible as modeling dimensions for all of the OFSAA analytical engines. Are expressed as columns in nearly all of your business fact tables Support both attributes and hierarchies..Standard Dimensions: Standard dimensions may support attributes and/or hierarchies depending on how they are configured, but are not used as processing dimensions.Simple Dimensions(Code dimensions,)Simple dimensions are "lists of values" that support neither attributes nor hierarchies.Total 150 simple dimensions .
Hierarchies may be used to provide sophisticated stratification for either processing or reporting purposes. For example, an organizational hierarchy might start with a Division level containing Western Region, Eastern Region, and Southern Region; the next level down within the hierarchy might be state or county. A product hierarchy might begin with branches for Asset vs. Liability vs. Service products; under the Asset branch, you might define additional Overview of OFSAA Infrastructure branches for Mortgage Lending, Commercial Lending, Consumer Lending, etc. Hierarchies are used extensively in OFSAA models to assign methods to products and to support allocation methodologies.
FSI_D OFSAA- Application Process Data-Element HierarchyEliminate specified data /values at instrument Eliminate specified data /values at HierarchyLevel(FSI_D/Entity) before processing level( product/organization) before processing. Select any where in the hierarchy GROUP: Combination of Data- Hierarchy filters are widely used in cost Element filters allocation and segmentation rules
Group Filters may be used to combine multiple Data Element Filters Example: Data Element Filter #1 filtered on mortgage balances greater than 100,000 Data Element Filter #2 filtered on current mortgage interest rates greater than 6%, you could construct a Group Filter to utilize both Data Filters. In this case, the resulting Group Filter would constrain your data selection to mortgage balances greater than 100,000 AND current mortgage interest rates greater than 6%.
Rate Management –Interest Rate 27
Based on yield curve The yield curve describes the relationship between a ,FI’s Can be issued particular redemption yield and a bond’s maturity. at Assets can be (Plotting the yields of bonds along the term structure will issued at higher give us our yield curve) maturity and liabilities issued at Yield curve usually plotted on Government –securities. lower maturity. It is important that only bonds from the same class of issuer or with the same degree of liquidity be used when plotting the yield curve. The yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth, and it helps to give an idea of future interest rate change Current yield =coupon interest /Market price
Boot strapping :implied future rates, known as implied forward rates, or simply forward rates, can be derived from a given spot yield curve boot-strapping.) Zero –coupon yield curve :The zero-coupon (or spot) yield curve plots zero-coupon yields (or spot yields) against term to maturity YTM-yield curve : The curve itself is constructed by plotting the yield to maturity against the term to maturity for a group of bonds of the same class.Yield curve points are taken from zero coupon BondsZero –coupon bond : The holder of a zero-coupon bond only receives the Face value of thebond at maturity. A zero-coupon bond does not pay Coupons or interest payments, to thebondholder .YTM-Cash outflow(Equal to the price of the bond) =cash inflows(periodic interest couponare received on maturity) +Redemption Value (received on final maturity
Vasicek : interest rates are dependent on market(short term interest ) & Economic activity.Hull & white : Deals with future interest rates .Ho-Lee: Interest rates which relates the bond to yield curve . the current yield curve is to be fixed .
Hybrid yield curves are built up from either one or more standard yield curves A Spread hybrid yield curve is defined as the difference between two standard yield curves. The "spread" type of hybrid yield curve may be useful in establishing liquidity risk or basis risk yield curves. Merged hybrid yield curves represent a blending of two or more underlying yield curves. In constructing a "merged" type of hybrid yield curve, you specify the percentage weighting applicable to each of the underlying standard hybrid yield curves. Moving average hybrid yield curves represent moving average data of a single underlying standard yield curve. These curves are typically used in Funds Transfer Pricing.
Functional currency Reporting currency (consolidated) Exchange RATEA foreign exchange rate is the price at which one currency can be exchanged for anothercurrencySpot :Involves the immediate exchange of currencies at the current (spot ) exchange rate .Forward Rate :is the exchange of currencies at a specified (or forward exchange rate ) over a specifieddate in the future . 32
OFSAA Rate Management provides a comprehensive list of 179 ISO-definedcurrencies; Reporting Currency A reporting currency is an active currency to which balances in other currencies may be Consolidated in order to facilitate reporting. Functional Currency: Balances in reporting currencies may be, in Reporting turn, consolidated to the functional currency. currency The functional currency is both an active currency and a reporting currency. Note: At the time of installation, Rate Management requires the installer to designate a Functional currency for the organization. function function function In our LAB …the functional currency: USD. al al al Currency Exchange rates: In order to establish setup the a process of currency exchange rate , first we define the from currency (fixed or pegged ) then we must supply as a To currency (float ) value . 33
Floating rateFixed rateBase CurrencyReporting currencyFunctional currencyDefault currencyNon-Currency Basis-Seeded currencies-179 If status will be active – then Reporting currency will be active (asking –Yes/No)
As of Date -All ALM processes refer this date at run time to determine the data to include in the process.The date that the extracted data represents.Origination Date :The date of the origination for the transaction account. This day may be in the future. or the past 36
•Defining Time Buckets are mandatory for Statutory Reporting purpose.(Time buckets allow you to specify the time periods used for storing and reportingresults.)•Time Bucket rules allow users to create the various time bucket definitions used forcomputing and outputting aggregated cash flows.•Time Bucket determines granularity of cash flow output and can be set at anyfrequency through a combination of daily, monthly and yearly buckets. 37
•It is a modeling • bucket set according • Interest Rate GAP •Liquidity GAP future start dates. Buckets allow you to Buckets are similar toIncome Simulation Buckets define Interest Rate GAP Liquidity GAP Buckets Interest GAP Buckets Interest Rate GAP buckets. •Income Simulation buckets. Bucket definitions • Dynamic Start Date are referenced by all allows definition of •The key difference is bucket based forecast forward start dates for that liquidity bucket business rules, computing dynamic impact only the market valuations. liquidity runoff •including Forecast financial elements. • The Dynamic Start Date Rates, Forecast allows exercise of Balances, Pricing Amortization of existing •The Dynamic Start Margins and business and any new Dates allow forecast Maturity Mix rules business assumptions. liquidity position as of and also by ALM some future date, Deterministic • Income Simulation Buckets are set up before Processes during defining Interest Rate •Considering relevant ALM engine GAP Buckets. assumptions, processing. •includingAmortizatio n,prepayments,Early withdrawals(early redemptions)and rollovers. 38
Product characteristic rules define payment, pricing and repricing characteristics for new business. They can used to specify calculation attributes for both existing accounts and new business.Product Profiles : Product Characteristic setup can be a time consuming process with more than 40 attributes, so Product Profiles allows to pre-define and save common product definitions and reference these definitions while defining Product Characteristic assumptions. Save common default values for the majority of required fieldsThe following Product Profiles are seeded during installation: Bond – Adjustable Rate, Bond – Fixed Rate, Credit Card, Discount Instrument, Lease, Loan – Adjustable Rate, Loan – Fixed Rate, Loan – Floating Rate, Loan – Negative Amortization, Savings, Term Deposit 39
Amortization : Paying off Debt in regular installments over a period of Time . Interest in arrears : Interest on loan which is due to be paid at the maturity date rather than periodically during the life of the loan . The interest leading up to the due date is payable but not yet paid . Interest in advance : borrowers can prepay the next years interest and claim it as a deduction when filing Taxes . Balloon payment : a type of loan which Is not fully amortized over its term . a balloon payment is required at the end of the term to repay the remaining principal of the loan . Negative Amortization: an increase in the principal balance of a loan caused by making payments that fail to cover the interest due Example : the periodic interest payment loan is 500,and a 400 payment may be paid contractually made .so remaining 100 is added to the Principal balance of the loan . OAS :is a discounting factor used for Market value & VAR (stochastic process ) Currency Exchange gain/loss: Model with Gross rates : Gross rates : used for prepayments & Amortization Net rates : used for income simulation &calculated for retained earnings in the auto balancing process
To Value and Estimate the interest rate risk of boththe MBS and ABS . 42
Mortgage: a mortgage is a loan secured by collateral of some of specified real estate property which obliges the borrower to make a series of payments. Mortgage is a contract , in which borrowers property is pledged as security for a loan , which is to be repaid on Installment Basis. (The mortgage gives the lender the right if the borrower defaults to ―foreclose ― on the loan and seize of the property in order to ensure that the debt is paid off ) The interest rate on the mortgage loan is called the mortgage rate or contract rate. Mortgage backed securities: MBS are backed by a pool of traditional residential mortgage loans called MBS . Asset Backed securities: Securities backed by loans other than traditional residential mortgage loans and backed by receivables are referred as ABS. 43
Patterns User defined patterns allow you to define custom repayment patterns for products in a portfolio Payment patterns: Differ in terms of how they Repricing Patterns: Define a series of Repricing Behavior Patterns:address payment patterns and events that The behavior patterns differschedules, which determine describe the interest rate in terms of how they allowwhether the payment events adjustment characteristics you to categorize cash flowsconstituting the pattern are over the life of a cash flow based on the specificdetermined by calendar dates instrument. behavior type being modeledor periods. Absolute: Payment characteristics Non –Maturity: commonly used for scheduled on specific calendar deposit products like checking, savings dates. and money market accounts as well as for Example: seasonal credit card accounts. schedule, such as agricultural or construction loans. Absolute These account types are similar in that they do not have contractual cash flows Relative: characteristics :Seasonal Pattern because customers have the option to deposit or withdraw any amount at any scheduled for certain periods of time. Relative : time (up to any established limits). Example: Modeling instruments with Graduated Rate Non Performing Behavior Patterns: commonly used for balances that are irregular payment frequencies. Mortgage. classified as Non-Earning assets(Non Performing Assets (NPA’s) ). Devolvement and Recovery Behavior Split: with both absolute and Patterns: relative payment events. commonly used for estimating cash flows associated with Letters of Credit and Example : Guarantees. multiple sets of payment patterns These product types are typically under a single amortization code categorized as off balance sheet accounts. 45
Example of a loan that follows a seasonal payment pattern, in which the payment patterns for January, February and March are scheduled for interest- only payments. As revenues for the customer increase, the payment amount also increases. Therefore, the payments for April and May are 80% of the original payment, and June through September is 100% of the original payment. The payment decreases as the production season slows. The payment for October is decreased to 80% of the original payment, and the payments for November and December are decreased again to 50% of the original payment
GraduatedMortgages :EMI’sstart at low leveland rise for a noof years & thenbecome equalafter specified noof yearsTraditionalMortgages:Repaid in equalmonthlyinstallments ofboth principal &Interest.
Spot IRCSpot Input Forecast –Original Term Forecast –Remaining Term 48
Discount Method rules allow users to define the method for discounting projectedcash flows for market value and duration calculation purposes.The methodologies contained in the Discount Method rules are referenced by theStatic Deterministic and Dynamic Deterministic ALM Processes. Spot Input Yield curve Forecasted Yield curve Spot Interest Rate Forecast Forecast Code(SPOT IRC): (Remaining (Original Term): Term) Discounts each cash Spot Input flow period by the Discounts each (single rate): equivalent term rate cash flow period by : Discounts each the forecasted cash flow period by Discounts all on the base yield curve value of the point the forecasted cash flows by chosen on the yield curve value of the point the same on the yield curve (the yield curve as of the corresponding to corresponding to Input Rate . start date selected in each transaction the remaining term your ALM Application records original (Term from the As- Preferences). term(Original Date) of –date)until each cash flow. 50
Total 12 months a period. Forecasted –Yield curve 3months Remaining term 9-months As-of-data
Loan profile of a bank will generally in long term in nature . Large volume of funds will be blocked in project financing and asset financing activities of the Institution . Securitization is a an effective way to release the funds for further investments . Securitization denotes process of selling assets by the person holding it to an intermediary , who in turn will break such assets in to marketable securities . In securitization future cash flows from advances (like mortgages ) made by Bank are repackaged in to negotiable certificates and issued to the investors . This arrangement induces the liquidity to the highly liquid assets . In the process of securitization also reduces the Interest rate risk , associated to the rate fluctuation . Mortgage pass through security :is a security created when 1 or more holders of mortgages form a collection (pool) of mortgages and sell shares or participation certifications in the pool ( a pool may consist of several thousand or only a few mortgages) . When a mortgage is included in a pool of mortgages that is used as collateral for a mortgage pass through security , the mortgage is to be securitized . 53
Prepayment: A payment made in excess of monthly mortgage payment is called prepayment . Home owners do payoff all (entire outstanding balance) or part (partial pay down of Mortgage Balance) of their mortgage balance prior to the date. Prepayment Risk: One of the major business risks faced by financial institutions engaged in the business of lending is prepayment risk. Prepayments, the amount and the timing of cash flows from a mortgagee loan are not known with certainty. Borrowers might choose the Repay part or all of their loan obligations before the scheduled date. . Prepayment –Methods : we cannot estimate the prepayment as in the same monthly EMI’S . So project a cash flow , is to make some assumption about the prepayment rate over the life of the underlying mortgage pool . 56
Constant Prepayment Method: Calculates the prepayment amount as a flat percentage of the current balance. Conditional Prepayment Rate (CPR) CPR is a annual prepayment rate. To estimate monthly prepayments, the CPR must be converted in to a monthly prepayment rate, commonly referred to as the Single monthly mortality Rate (SMM) SMM= 1-(1-CPR)^1/12.Public Securities Association Standard(PSA)–Method: expressed as monthly series of CPR’s. Assumes Prepayments are low for a newly originated mortgaged balance and then will speed up as the mortgages become seasoned.Arctangent Calculation Method: Analyze the prepayment behavior.The Arctangent Calculation method uses the Arctangent mathematical function to describe the relationship between prepayment rates and spreads (coupon rate less market rate).Specifically: CPRt = k1 - (k2 * ATAN(k3 * (-Ct/Mt + k4)))where CPRt = annual prepayment rate in period t Ct = coupon in period t Mt = market rate in period t k1 - k4 = user defined coefficients 57
The arctangent formula describes the relationship between prepayments and the ratio of coupon rate to market rate.For 100% PSA1) 0.2% CPR =for the first month.2) Increased by 0.2%peryear per month for the next 30 months ..until it reaches 0.6%3) A 6% CPR for the remaining months
Curtailment: The prepayment could be the pay-off the entire outstanding balance or a partial pay down of the mortgage balance. When the pre -payment is not for the entire outstanding balance it is called curtailment . Refinance: Refinancing is the tendency of the borrower to pre- close a costly loan and see the property refinanced with a cheaper loan . Borrowers refinance for several reasons: to reduce the rate, reduce payments, reduce risk of future rate increases, and raise cash. Seasonality: Seasonality pattern is related to activity in the primary housing market, with home buying activity increasing in the spring, and gradually reaching a peak in the late summer. Home buying activity declines in the fall and winter. Mirroring this activity are prepayments that results from the turnover of housing as home buyers sell their existing homes and purchase new ones. 59
Early Redemption(Early withdrawal): The Repurchase of a bond by the issuer before it matures. Early redemption fees are often charged in the early years of many fixed rate ,capped rate or cash back mortgages, when they are repaid early. If you are working with deposit products, it is possible to define Early Redemption assumptions within the Prepayment Rule. 60
Conditional Assumptions can be applied only on detailed accounts (data stored in the Instrument Tables) and reference only the Cash Flow and Dimension columns that are part of the Instrument Tables. Conditional Assumptions are ignored when processing forecast balances. You can define prepayment methodologies using IF-THEN-ELSE logic based on the underlying characteristics of your financial instruments, such as dates, rates, balances, and code values. 61
Use currency exchange rate forecasts to account for the effects of currency fluctuations on income(RSA,RSL ‘s for change in NII) Use interest rate forecasts to project cash flows, including pricing new business, re-pricing existing business, calculating prepayments, and determining discount methods. Use Economic Indicator forecasts to include in behavioral modeling and scenario/stress analysis. Scenarios : You can also set minimum rates (or floors) on any rule created for Currency, Interest Rate. For example, if you want to run a -200bp rate scenario, with short term rates <2%, you can set the minimum rate to floor at 0%, although negative rates are allowed if desired.
For interest code –interpolation methods
Forecast Balances: Rate-Volume Modeling-Forecast Rate Dependency Patterns:To discusses modeling of new business Balances: Customer demand for new Rate Dependency Patterns allowactivity through the Forecast Balance you to establish relationships products often depends on interest rates or between the level of interestrules. other variables such as macro-economic rates, Rate spreads and ALM drivers. You can model this behavior by selecting a Rate—Dependency assumption. forecast assumption rules . Objective :Tailor the new business assumptions to meet your expectations of future originations, including the timing of new business and the effect of interest rates on new business amounts. Pricing Margin: allow users to define pricing margins (or spreads) for your products. Pricing margins work together with a underlying base interest rate curve to determine note rate pricing for new business volumes defined through Forecast Volume Detail Maturity Mix: Allow you to Balance rules. Growth : Define the Term distribution Percentage of growth of new business added % with in each during each forecast period. Modeling Bucket You create Maturity Mix rules (Income simulation to define the maturity and Bucket). amortization term for new . business volumes. . 65
Rate-Level Dependent Rate-Spread Dependent Interpolation Range Rate Lag: Period by which repricing lags the current interest rate changes.Rate Lag :Defined for New Business Assumptions and Depends on the TimingOptionsRate Tiers :Defined for Spread
Rate -Tiers Base- Interes t Rate -Tiers Modeling Interest Rates:at above or below Market Interest codes Using with Income simulation Buckets . Example : 25 Bp above the Market yield curve Gross Margin :Used for Pre-payment &Amortization Net Margin :Retained Earnings in the Auto Balancing ProcessProduct characteristics : All Business: Enable Model with gross rate .New Business : Define Payment attributes Net margin flag Floating Net Rate Fixed Net rate
ALL business :Enable :Model with Gross rate Product characteristics-Define New Business assumptions New Business : define Payment attributes : Net margin Flag Float Net rate . Fixed Net arte Select Product and currency Rate dependency patterns- Rate TIERS Pricing margins- Modeling Interest rates Net Margin Gross MarginNet margin : Net Rate is affected by setting the net marginflag in product char rule . Gross margin = Gross rate (defined inNet margin is set to fixed rate : Then net margin = Rate product characteristic rule ) +Added( Interest -code ) +Net margin flag specified . Interest (Defined in New Business)Net margin is set to fixed rate :Then Net Margin= Rate (Net ) 69
Rate -Tiers Base- Interest Rate -Tiers Income Simulation Buckets Start Buckets Maturity Date (Min value) MM (Modeli ng Per bucket) Amortization End Buckets Date Max value New Business Assumption Rate-Lag Note :Amortization term should always be greater than or equal toDynamic ALM maturity term .
Example : Mortgage originations may be divided in to 25%----- 5 year term(Maturity ) –--- 30 year Amortization 25% ----- 7 year term ---- 30 year Amortization. 50% -----30 year term ----- 30 year amortization .You attach the set of maturity assumptions to apply all new business volumes with in a dynamic ALM. 72
Rate -Tiers Base- Interes t Rate -Tiers New Business Timing Options: Distributed :Result reach an expected average balance in Between beginning and Ending balance .(Roll-Over 3 Methods are Applied ) At Bucket End: generate result at the End of the Modeling bucket . result in irregular average balances & Interest accruals over the bucket Rate lag defined for New business assumptions and depends on Timing of options New Business Assumptions with Volume Detail(growth%) Rate-LagIf New Business option uses1) Uses forecast interest rates (from Rate tires )- as of date with in the current modeling bucket (term ) less the Rate lag .2) End of the bucket term uses - the look up uses the last day of the bucket less the rate lag .3) For all other cases the mid point of the bucket less the rate lag .
methods defines at Each Modeling Bucket No-New New-Add- Target Roll-over Business BusinessForecast –Zero Exact Amt Average Roll-Overchange in (Absolute) ofBusiness New Business Expected Average Reinvestment (Extension) of Balance per Modeling Is Added. Bucket Principal of an Existing Account. Roll-over End with New - Add Total Expected Balance Reinvestment of Existing by the End of the A/C Plus Expectation of Modeling Bucket New Business Amount Growth Growth Expected Percentage Both Roll-Over change in the over a Assumptions & Overall Modeling Bucket Growth Percentage (X2-X1/X1)*100 Assumptions
Percentage of growth % with in each Modeling Bucket (Income simulation Bucket). you select the Range of modeling buckets and input balance or percentage assumptions for each modeling bucket within this bucket range
Derivatives are used to minimize Interest Rate Risk by using hedging or speculation.With respect to the ALM process, options can be used for reducing risk and enhancing yield.Call option strategies are profitable in bullish(if the market rallies ) interest rate scenarios with the maximum loss restrictedto the upfront premium.Put options can be used to provide insurance against price declines, with limited risk if the opposite occurs. A futures contract is an agreement between a buyer and seller to exchange a fixed quantity of a financial asset at an agreed price on a specified date. Interest rate futures (IRF) can be used to control the risk associated asset liability GAP Interest rate swaps (IRS) represent a contractual agreement between a financial institution and a counterparty to exchange cash flows at periodic intervals, based on a notional amount. By arranging for another party to assume its interest payments, a bank can put in place such a hedge. Financial institutions can use such swaps to synthetically convert floating rate liabilities to fixed rate liabilities. Example :In case of a falling interest rate scenario, prepayment will increase.
With the Transaction Strategy rules you can Test the impact of various hedging strategies that are integrated with Basic scenario modeling assumptions. Hedging :Try to minimize Risk (IRR/ER), not bothered about profits. Arbitration :Generate profits –Is a process of where you try to take the advantage of market discrepancies (look profits by minimize risk ) These transaction strategies will be used to measured the interest rate risk using derivative instruments like Futures ,options, Forward contracts and swaps . 79
Interest rate Futures 80
A futures contract is a type of derivative instrument, or financial contract, in which two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. If you buy a futures contract, you are basically agreeing to buy something that a seller has not yet produced for a set price. The futures market is extremely Liquid ,risky and complex by nature.Futures Position : A futures contract is an agreement between two parties: A short position - the party who agrees to deliver a commodity . A long position - the party who agrees to receive a commodity. The profits and losses of a futures contract depend on the daily movements of the market for that contract and are calculated on a daily basis 81
Futures can be used either to hedge or to speculate on the price movement of the underlying asset.Currency Futures: A transferable futures contract that specifies the price at which a currency can be bought or sold at a future date. Currency future contracts allow investors to hedge against foreign exchange risk.Interest rate futures : A futures contract with an underlying instrument that pays interest. An interest rate future is a contract between the buyer and seller agreeing to the future delivery of any interest-bearing asset. The interest rate future(IRF) allows the buyer and seller to lock in the price of the interest-bearing asset for a future date. 82
ProfitabilityThis financial contract gives aright to its holder to enter into atrade at or before a futurespecified date. 83
An option is a right to buy or sell an underlying asset at a future date at an agreed price.A financial derivative that represents a contract sold by one party (option writer) to anotherparty (option holder). Call Option :An option contract is called a ‘call option’, if the writer gives the buyer of the option the right to purchase from him the underlying asset. Put Option :An option contract is said to be a ‘put option,’ if the writer gives the buyer of the option the right to sell the underlying asset. Exercise Date :The date at which the contract matures. Strike Price(Exercise Price) :At the time of entering into the contract, the parties agree upon a price at which the underlying asset may be bought or sold. 84
American options :An options, can be exercised on any day during the expiration period are called American options. European options :can be exercised only on the last day(always) of the expiration period. Bermuda option : A type of exotic option that can be exercised only on predetermined dates, typically every month. Bermuda options are a combination of American and European options. Bermuda options are exercisable at the date of expiration, and on certain specified dates that occur between the purchase date and the date of expiration. 85
At-the-money: Exercise price is equal to the current spot price In-the-money: Call option : s>k strike price is below the current spot price of the underlying asset; Put option : k>s The strike price is above the current spot price of the underlying asset. Out-of-the-money: Call option : k>s the strike price is above the spot price of the underlying asset Put option : s>k the strike price is below the current spot price of the underlying asset. The buyer makes a loss if he exercises the option out-of-the-money. Position Limit: The maximum number of options contracts per investor. Exercise Limit: The maximum number of contracts that can be exercised per investor. 86
Both are used in Montecarlo analytics. FLOOR CAP If interest rates rise above the agreed cap rate then A floor is an agreement where the seller agreesthe seller pays the difference between the cap rate to compensate the buyer if interest rates falland the interest rate to the purchaser. below the agreed upon floor rate. A cap is usually bought to hedge against a rise ininterest rates and yet is not a part of the loan It is similar to a cap, but ensures that if theagreement and may be bought from a completely interest rate falls below a certain agreed floordifferent bank/writer. limit, the floor limit interest rate will be paid
Intrinsic Value :is the value of the profits that are likely from the option. The Intrinsic Value is also the value of an option takes when it is in-the-money. For a call it is max (0, S – k) For a put it is max (0, k – S) where S and k are spot price and strike price of the underlying asset respectively. Time Value The difference between the option premium and the intrinsic value. 88
Interest rate swaps Currency swaps Basis swap Forward rate swapsSwap :Refers to the simultaneous purchase and sale of currency(at agreedexchanged rate ) for different maturities or vice versa 89
There are two parties to a swap transaction, fixed rate payer/receiver and floating rate receiver/payer. A fixed rate payer is the provider of floating rate funds and Hence the purchasers(Buyer ) of the swap lose when interest rate falls and gain when interest rate rises. A floating rate payer is the provider of fixed rate funds and Hence the seller of the swap loses when interest rate rises and gains when interest rate falls 90
Plain Vanilla or coupon or Generic Swap: The plain vanilla swaps are those swaps where fixed rate obligations are exchanged for floating rate obligations over a specific period of time on a notional principal Basis Swap: A swap in which a stream of floating interest rates are exchanged for another stream of floating interest rates, is known as basis swap Interest rate swap : An interest rate swap is defined as an agreement between two or more parties who agree to exchange interest payments over a specific time period on agreed terms. The interest rates agreed may be fixed or floating. currency swap A currency swap is a contract involving exchange of interest payments on a loan in one currency for fixed or floating interest payments on equivalent loan in a different currency. Currency swaps may or may not involve initial exchange of principal. A plain vanilla currency swap is a fixed-fixed currency swap in which each party pays a fixed payment on the loan taken by them Forward Swaps Forward swaps are those swaps in which the commencement date is set as a future date. Thus, it helps in locking the swap rates and use them later as and when needed. Forward swaps are also known as deferred swaps . Amortizing Swaps If the interest rates are fairly stable then the floating payments are also reduced over time. This swap is particularly useful if a swap is undertaken to manage the risk arising from mortgage loans. 91
An interest rate swap (IRS) is a contract that exchanges interest payments between two differently indexed legs, of which one is usually fixed whereas the other one is floating. When the fixed leg is paid and the floating leg is received the interest rate swap is termed payer IRS and in the other case receiver IRS.
Stochastic Rate index :The purpose of the Stochastic Rate Indexing Rule is to establish relationships between a risk-free Interest Rate Code (IRCs) and other interest rate codes or Indexes used for re-pricing existing business and pricing new business. Example of non risk free (dependent) curves are: LIBOR ,Prime rate The Stochastic Rate Indexing rule is a required assumption rule, that you select within a Stochastic ALM Process to calculate Value at Risk and Earnings at Risk. 93
Static Analysis is the fundamental platform on which the ALM function of the Bank is built. It is generally observed that a large number of Banks that offer the conventional banking products are able to address their considerations of adequate liquidity and sources of short term funds with the Static ALM analysis. Banks are able to fine tune any assumptions in order to meet their strategic objectives. 94
Dynamic ALM: is practiced by Banks where the market environment is extremely active and very competitive and often require the bank to realign their business strategies. It is also useful when the complexity of operations is high. Accurate evaluation of current exposures of asset and liability portfolios to interest rate risk. Changes in multiple target variables such as net interest income, capital adequacy, and liquidity . Future gaps 95
Static Dynamic Deterministic Stochastic (Present (New Business (Scenario/sensiti (Simulation) Business) Assumptions) vity)Balance–sheets aremaintained at Analysis for Various Monte carlosame level . Projected B/Sheet. simulation. Scenario (Forecasted(Existing Business Analysis Projections). Ex:2%,3%,4% SimulateBusiness Assumptions variety of Positions(OFSA Staging which can be Discrete scenarios. created andArea) managed in OFSA (uniform/conti ALM nuous)Basic analysis ->Information distribution. Random-(output is limited about Future Distribution.to the existing businessB/sheet). Plans .
OFSAA ProcessingSource InstrumentSystems ETL - OWB OFSAA Tables Application Loans FSI_D_LOAN_CONTRACT S Term FSI_D_TERM_DEPOSITS Deposits Extraction FSI_D_CASA OFSAA uses FSI_D_INVESTMENTS the Instrument tables and Transformatio FSI_D_CREDIT_CARDS CASA configurations n FSI_D_CREDIT_LINES done and FSI_D_DERIVATIVES generates the result Loading FSI_D_SWAPS Treasury FSI_D_FX_CONTRACTS etc. Credit Cards
OFSAA generates cash flows at the individual instrument level. Each individual instrument recordprocessed, generates a unique set of cash flows as defined by that instrument record’s productcharacteristics. Source- ETL-OWB OFSAA- (Mapping ) Instrument Application Systems Extraction Transformation Tables ( OFSAA uses the Instrument (CBS/Treasury) Loading tables and configurations done and generates the result) Loans Data staging Area FSI_D_LOAN_CONTRAC TS Term Deposits OFSAA- FSI_D_TERM_DEPOSIT S source-Data Transformation/Look up Mirror FSI_D_CASA (Each) Tables Tables CASA FSI_D_INVESTMENTS PRODUCT_ID Product Name Extraction: Extracts ACCRUAL_BASIS_CD FSI_D_CREDIT_CARDS the data from flat files ADJUSTABLE_TYPE_CD Day Basis Transformation :The Credit INT_TYPE FSI_D_CREDIT_LINES Fixed or Floating -loan phase in which the Cards COMPOUND_BASIS_CD Type raw data from the FSI_D_DERIVATIVES source system is COMMON_COA_ID Interest Timing converted to the AMRT_TYPE_CD FSI_D_SWAPS desired format. Simple or Compound Loading :The process REMAIN_NO_PMTS_C Treasury REPRICE_FREQ FSI_D_FX_CONTRACTS of loading data into Asset the final target tables REPRICE_FREQ_MULT etc. (OFSAA) after AMRT_TERM EMI Or Interest-Rate thorough validation Type Only and quality check is a AMRT_TERM_MULT part of this phase 98
Reporting RequirementsSLR -Structural Liquidity ReportsIRS - Only Interest Rate Derivatives are included.DLR - Dynamic Liquidity Reports .ADHOC -Reports