Handbook of Asset and Liability Management: From Models to Optimal Return Strategies (The Wiley Finance Series)

In the __Handbook of Asset and Liability Management: From Models to Optimal Return Strategies__, Alexandre Adam presents a comprehensive guide to Asset and Liability Management. Written from a quantitative perspective with economic explanations, this book will appeal to both mathematicians and non-mathematicians alike as it gives an operational view on the business. Well structured, this book includes essential information on Balance Sheet Items and Products Modeling, Tools for Asset and Liability Managers, as well as Optimal Returns Strategies. Explaining, in detail, all the written and unwritten rules of Asset Liability Management, using up-to-date models and the latest findings, the __Handbook of Asset and Liability Management__ is an essential tool for Asset and Liability Managers both for the present day and the future. Handbook of Asset and Liability Management 3 Contents 9 Preface 15 Acknowledgments 19 About the author 21 PART I INTRODUCTION 23 1 The History of ALM 25 1.1 The history of the banking industry from antiquity to the Middle Ages 25 1.2 The modern banking industry and the history of ALM 27 1.3 The history of the insurance industry and ALM 29 1.4 The history of other businesses and ALM 31 2 What is Asset and Liability Management Today? 35 2.1 ALM and the banking industry 35 2.2 Other general ALM questions 36 PART II INTERNAL TRANSFER PRICING, ACCOUNTING AND AUDITING 39 3 Balance Sheet Presentation 41 3.1 General balance sheet presentation 41 3.2 A/L manager’s balance sheet presentation 41 3.3 Banking Book and Insurance Book 45 3.4 Income statement and statement of cash flows 47 4 “Accrued Accounting” for Interest Rate Instruments Versus “Marked-to-Market” Accounting 51 4.1 General principles 51 4.2 Accrued accounting examples 52 5 IFRS and IAS Accounting 55 5.1 IFRS, international organizations and rule presentation 55 5.2 IAS 39 57 5.3 Financial disclosures 70 5.4 IFRS and insurance 75 5.5 Other IFRS specificities 76 5.6 Impact of IFRS on ALM and criticism of IFRS 78 6 “Economic Accounting”: Fair Value and Full Fair Value 81 7 Internal Transfer Pricing or Fund Transfer Pricing (FTP) 83 7.1 Principles 83 7.2 Advanced transfer pricings including credit risk and expected return on economic capital 86 7.3 The inclusion of implicit options inclusion in the “contract by contract” FTP rules and commercial department arbitrage opportunity 88 7.4 FTP rules based on the “stock” and based on the “flows” 89 7.5 Examples of FTP rules 94 7.6 Perequations 99 8 ALM as a Profit Centre 103 8.1 One profit centre for one financial risk 103 9 Optimal Organization of an ALM Team 105 9.1 The usual ALM organization 105 9.2 The objectives of ALM 106 9.3 ALCO: the ALM committee 109 9.4 The different ALM teams 115 PART III BALANCE SHEET ITEMS AND PRODUCTS MODELLING 121 10 Behavioural Modelling Principles 123 10.1 The constitution of databases 123 10.2 Event driven modelling 125 10.3 Modelling the strategy of the company 126 10.4 Expert advice 127 10.5 Model backtesting 127 11 Deposits and Savings 129 11.1 Deposits, monetary aggregates, money supply and macroeconomics 129 11.2 Demand deposit accounts 133 11.3 Saving accounts: regulated and non-regulated savings versus super-savings 138 11.4 Demand deposits models in the literature 140 11.5 Deposit modelling: the solution through an approach based on customer behaviour modelling 146 11.6 Deposit modelling through a customer behaviour modelling based approach: representation in risk indicators and FTP 154 12 Loans 161 12.1 Different types of loan 161 12.2 Different definitions and formulae 163 13 Prepayments 167 13.1 The origins of the prepayment phenomenon 167 13.2 The constitution of the database for prepayment modelling 181 13.3 Different models: historical database-based approaches and MBS-based approaches 188 13.4 Prepayment scoring 200 13.5 Prepayment monitoring 200 14 Other Examples of Products Needing Behavioural Modelling 203 14.1 Pipeline risk 203 14.2 Margin delay effects such as “whistle effects” 204 14.3 Other volume effects options 205 15 Examples of Products Partially Correlated with Financial Markets 207 15.1 Presence of correlation between the cash flows and financial markets: examples of credit card 207 15.2 Costs and commissions correlation with financial markets 207 15.3 Examples of embedded options 208 16 New Production Modelling 209 16.1 New contract production 209 16.2 Commission and cost modelling 214 16.3 Perequation modelling 215 16.4 Future strategies modelling 215 17 Insurance Products 217 17.1 Unit of account contracts 217 17.2 Mutual funds 217 18 Hedging Instruments 219 18.1 Derivatives 219 18.2 Bond strategies 219 18.3 Mortgage Backed Securities 220 PART IV RISK MANAGEMENT FOR ASSET AND LIABILITY MANAGERS 223 19 Financial Risks 225 19.1 Liquidity risk 225 19.2 Credit risk 242 19.3 Interest rate risk 257 19.4 Inflation risk 281 19.5 Currency risk 287 19.6 Corporate stock market risk 295 19.7 Real estate risk/property risk 296 19.8 Other financial risks 299 20 Non-Financial Risks 303 20.1 Operational risks 303 20.2 Model risks 304 20.3 Business risk 304 20.4 Risk correlations 305 20.5 “Accounting risk”: the risk representation depends on the accounting scheme! 305 PART V TOOLS FOR ASSET AND LIABILITY MANAGERS 307 21 Simulation Tools for Interest Rates and Other Financial Indexes 309 21.1 Stochastic calculation 309 21.2 Equity market simulation 314 21.3 Interest rate simulation 318 21.4 Generic models for joint simulation of inflation, stock index, interest rates, real estate, liquidity and credit spreads 328 21.5 Market simulations including risk premiums 331 22 Delta Equivalent Computation 337 22.1 Principles 337 22.2 Delta, penta, correla and courba equivalents or “Adam equivalents” 344 22.3 Delta equivalent associated break-even point 348 22.4 Examples of delta equivalent computation 349 22.5 Hedging error and gamma equivalent 356 23 Technical Tools Useful in ALM 361 23.1 Risk measures 361 23.2 Optimization methods 366 23.3 Common statistical tools in ALM 369 23.4 Other statistical tools and common ALM functions 377 PART VI ECONOMIC VALUE AND NEW RISK INDICATORS ASSOCIATED WITH THE BASEL II AND SOLVENCY II REGULATORY PERSPECTIVE 379 24 Basel II Regulation and Solvency II 381 24.1 Common regulatory risk constraints 381 24.2 Basel II: normalized regulatory constraints 382 24.3 Solvency II 400 25 Links Between ALM and Financial Analysis 403 25.1 Performance indicators in the company 403 25.2 Shareholder’s equity value, economic value and risk premiums 405 25.3 Capital allocation/attribution and capital consumption 408 25.4 Company valuation and cost of capital with positive tax rate 409 25.5 Merton’s model 413 25.6 Financial analysis and ALM implications 413 26 Towards Economic Capital Indicators 415 26.1 Economic capital and its implications 415 26.2 Economic capital computation main hypotheses 420 26.3 ALM stress testing 423 26.4 Credit risk economic capital computation 428 26.5 Economic capital in ALM 429 26.6 IFRS and regulation implications for ALM 455 26.7 New indicators for the economic value approach 457 PART VII OPTIMAL RETURN STRATEGIES 463 27 Risk Perfect Hedging Using the Delta Equivalent Technique 465 27.1 Micro hedging strategies with structured products 465 27.2 Delta hedging strategies 466 27.3 Example of a bank balance sheet with demand deposits 470 28 Limits Policy 475 28.1 Economic capital limit 475 28.2 Setting economic capital limits 476 28.3 Gap limit 476 28.4 Income sensitivity limit 477 29 Income Smoothing Strategies 479 29.1 Important preliminary comment about income smoothing and fraud 479 29.2 Examples of income smoothing 480 29.3 Example of a cumulative AFS bonds income smoothing strategy 482 29.4 ALM and Hawks martingale 483 30 Economic Value Management: The A/L Manager’s Optimization Programme Under Economic Capital Constraints and Accounting Constraints 485 30.1 Point of view of “traditional A/L managers” and criticism of the models 485 30.2 Economic value management 488 30.3 Economic value optimization using grid methodology 492 31 Application to Banking Book Activities 495 31.1 Deposit accounts: valuation and hedging in an economic capital approach using the grid methodology 495 31.2 Application to Stock Market Book 504 31.3 Application to Credit Risk Book 505 31.4 Prepayment risk optimal hedging strategies 506 31.5 Application to a global Banking Book including business and model risk 507 31.6 Direct demand deposit income smoothing through a simple example 509 32 Economic Value Management in Insurance Companies and in Capital Book Management 513 32.1 Economic value management in insurance companies 513 32.2 Application to economic Capital Book management 514 PART VIII CONCLUSIONS ON THE ALM OF TOMORROW 517 33 Conclusions on the Future of ALM 519 33.1 ALM diversity 519 33.2 ALM benchmarking 522 33.3 Conclusions on ALM and models 522 PART IX ANNEXES 529 34 Statistical Advanced Tools 531 34.1 Extreme points 531 34.2 Copulas 531 35 The Basis of Interest Rate Modelling 535 35.1 Yield curve reconstitution 535 35.2 Yield curve stochastic interest rate models 543 Bibliography 555 Index 563

"This book is a comprehensive and authoritative presentation of ALM techniques and issues. It covers modeling and practical aspects of ALM and greatly benefits for the author's experience within the ALM group of BNP-Paribas. I think anyone from the student involved in a risk management degree to the skilled practitioner will benefit from this useful reading."

—Professor Jean-Paul Laurent, Professor of Finance, ISFA Actuarial School, University of Lyon

"Alexandre Adam has provided an excellent and detailed treatment of Asset and Liability Management. This Handbook will be a very useful and complete guide to practitioners inasmuch as it analyses in a coherent framework the following three aspects: accounting (with respect to IFRS and IAS), organisation and regulation (for both Basel II and Solvency II). Moreover it integrates the ALM with the recent Risk Management techniques for the more relevant sources of risk (credit, liquidity, operational risks)."

—Professor Domenico Sartore, Department of Economical Sciences, Universita' Ca' Foscari di Venezia

"Starting with a look at the history of Asset and Liability Management and the current climate, the book then examines a range of accounting and auditing obligations, including IFRS and balance sheet presentation. Balance sheet items and products modelling are then explained in detail as well as the entire associated range of financial and non-financial risks. As well as the practical issues encountered by ALM managers, the Handbook of Asset Liability Management also considers the growing quantitative aspects of the role, looking at a range of technical tools and applications including market simulations, stochastic calculations, delta equivalent computations, and traditional and non-traditional statistical tools." "The book then discusses capital requirements within the ALM context, notably the impacts of Basel II and solvency II and economic capital indicators. The final section of the book explains optimal return strategies, looking at risk perfect hedging, limits policies, income smoothing strategies and economic value management."--Jacket