OFSAA-ALM

Oracle Financial Services
Analytics 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 order
to 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 of
its 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 Equity

NII: The difference between the revenue that is generated from the Banks assets & the
expenses associated with paying out liabilities is NII.NII is more sensitive(Volatile) to the
changes in interest rates.
NIM = -VE represents firm did not make an optimal decision =>the firm has los more
money 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 to
the interest rate fluctuations.

•The banks results of operations are substantially dependent upon the
level 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 international
economic and political conditions and other factors.

• Changes in interest rates could affect the interest rates charged on
interest-earning assets and the Interest rates paid on interest-bearing
liabilities 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 raise
necessary 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 an
institution’s ability to Approaches :
meet its liabilities Fund management ….managing surplus &
either by borrowing or
converting 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 foreign
arise from a variety of sources currency dealing or trading activates.
such as foreign exchange
trading, investments Translational exposure (Accounting Exposure) :
denominated in foreign
arises form overall asset /liability
currencies and investments in
foreign companies, making infrastructure of both on/off Balance sheets
foreign currency loans
, buying foreign currency VAR approach to risk associated with
securities or issuing foreign FX-exposures
currency -denominated debt
,foreign currency retail External approach:
accounts and retail cash Forward contracts
transactions and services,.
Options
Swaps

---------Currency gain/loss-----
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Master Maintenance

Dimensions Management
Hierarchies
Filters
Rate Management

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 dimensions
Key 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 Hierarchy

Eliminate specified data /values at instrument Eliminate specified data /values at Hierarchy
Level(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 Bonds
Zero –coupon bond : The holder of a zero-coupon bond only receives the Face value of the
bond at maturity. A zero-coupon bond does not pay Coupons or interest payments, to the
bondholder .

YTM-Cash outflow(Equal to the price of the bond) =cash inflows(periodic interest coupon
are 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 RATE

A foreign exchange rate is the price at which one currency can be exchanged for another
currency
Spot :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 specified
date in the future . 32

OFSAA Rate Management provides a comprehensive list of 179 ISO-defined
currencies;
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 rate
Fixed rate
Base Currency
Reporting currency
Functional currency
Default currency
Non-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 reporting
results.)
•Time Bucket rules allow users to create the various time bucket definitions used for
computing and outputting aggregated cash flows.
•Time Bucket determines granularity of cash flow output and can be set at any
frequency 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 to
Income 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 fields
The 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 both
the 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 differ
schedules, which determine
describe the interest rate in terms of how they allow
whether the payment events
adjustment characteristics you to categorize cash flows
constituting the pattern are
over the life of a cash flow based on the specific
determined by calendar dates
instrument. behavior type being modeled
or 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

Graduated
Mortgages :EMI’s
start at low level
and rise for a no
of years & then
become equal
after specified no
of years

Traditional
Mortgages
:Repaid in equal
monthly
installments of
both principal &
Interest.

Spot IRC

Spot Input Forecast –Original Term Forecast –Remaining Term
48

Discount Method rules allow users to define the method for discounting projected
cash flows for market value and duration calculation purposes.

The methodologies contained in the Discount Method rules are referenced by the
Static 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
record's 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% PSA

1) 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

Currency Forecasting-Forward rates
Interest Rate Forecasting

Rate shock Analysis

62

 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 allow
activity through the Forecast Balance you to establish relationships
products often depends on interest rates or
between the level of interest
rules. 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 Timing
Options
Rate 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 Process

Product 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 Margin

Net margin : Net Rate is affected by setting the net margin
flag in product char rule . Gross margin = Gross rate (defined in
Net 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 to
Dynamic 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-Lag
If New Business option uses
1) 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 Business

Forecast –Zero Exact Amt Average Roll-Over
change in (Absolute) of
Business 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 restricted
to 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

Profitability

This financial contract gives a
right to its holder to enter into a
trade at or before a future
specified 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 another
party (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 agrees
the seller pays the difference between the cap rate to compensate the buyer if interest rates fall
and the interest rate to the purchaser. below the agreed upon floor rate.

A cap is usually bought to hedge against a rise in
interest rates and yet is not a part of the loan It is similar to a cap, but ensures that if the
agreement and may be bought from a completely interest rate falls below a certain agreed floor
different 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 swaps

Swap :Refers to the simultaneous purchase and sale of currency(at agreed
exchanged 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 are
maintained at Analysis for Various Monte carlo
same level . Projected B/Sheet. simulation.
Scenario
(Forecasted
(Existing Business Analysis
Projections). Ex:2%,3%,4% Simulate
Business
Assumptions variety of
Positions
(OFSA Staging
which can be
Discrete scenarios.
created and
Area) managed in OFSA (uniform/conti
ALM nuous)
Basic analysis ->Information distribution. Random-
(output is limited about Future Distribution.
to the existing business
B/sheet). Plans .

OFSAA Processing
Source Instrument
Systems 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 record
processed, generates a unique set of cash flows as defined by that instrument record’s product
characteristics.

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 Requirements

SLR -Structural Liquidity Reports

IRS - Only Interest Rate Derivatives are
included.

DLR - Dynamic Liquidity Reports .

ADHOC -Reports

OFSAA-ALM

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