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1/18/2016 Examples Of Asset/Liability Manag ement | Investopedia
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What Is Asset/Liability Management?hat Is Asset/Liability Management?
Although it has evolved over time to reflect changing circumstances in the economy andlthough it has evolved over time to reflect changing circumstances in the economy and
markets, in its simplest form,arkets, in its simplest form, asset/liability managementsset/liability management entails managing assets and cashentails managing assets and cash
inflows to satisfy various obligations. It is a form of risk management, whereby onenflows to satisfy various obligations. It is a form of risk management, whereby one
endeavors to mitigate or hedge the risk of failing to meet these obligations. Success in thendeavors to mitigate or hedge the risk of failing to meet these obligations. Success in the
process may increase profitability to the organization, in addition to managing risk.rocess may increase profitability to the organization, in addition to managing risk.
Some practitioners prefer the phrase "surplus optimization" as better to explain the need toome practitioners prefer the phrase surplus optimization as better to explain the need to
maximize assets available to meet increasingly complex liabilities. Alternatively, surplus isaximize assets available to meet increasingly complex liabilities. Alternatively, surplus is
known as net worth, or the difference between the market value of assets and the presentnown as net worth, or the difference between the market value of assets and the present
value of the liabilities and their relationship. The discipline is conducted from a long-termalue of the liabilities and their relationship. The discipline is conducted from a long-term
perspective that manages risks arising from the interaction of assets and liabilities; as such, iterspective that manages risks arising from the interaction of assets and liabilities; as such, it
is more strategic than tactical.s more strategic than tactical.
A monthly mortgage is a common example of a liability that a consumer has to fund out of monthly mortgage is a common example of a liability that a consumer has to fund out of
his or her current cash inflow. Each month, the individual faces the task of having sufficientis or her current cash inflow. Each month, the individual faces the task of having sufficient
assets to pay that mortgage. Financial institutions have similar challenges, but on a muchssets to pay that mortgage. Financial institutions have similar challenges, but on a much
more complex scale. For example, aore complex scale. For example, a pension planension plan must satisfy contractually establishedmust satisfy contractually establishedbenefit payments to retirees, while at the same time sustain an asset base through prudentenefit payments to retirees, while at the same time sustain an asset base through prudent
asset allocationsset allocation and risk monitoring, from which to generate these ongoing payments.and risk monitoring, from which to generate these ongoing payments.
As you can assume, the liabilities of financial institutions can be quite complex and varied.s you can assume, the liabilities of financial institutions can be quite complex and varied.
The challenge is to understand their characteristics and structure assets in such a way as to behe challenge is to understand their characteristics and structure assets in such a way as to be
able to satisfy them. This may result in an asset allocation that would appear suboptimal (if ble to satisfy them. This may result in an asset allocation that would appear suboptimal (if
only assets were being considered). Asset and liabilities need to be thought of as intricatelynly assets were being considered). Asset and liabilities need to be thought of as intricately
intertwined, rather than separate concepts. Here are some examples of the asset/liabilityntertwined, rather than separate concepts. Here are some examples of the asset/liability
challenges of various financial institutions and individuals.hallenges of various financial institutions and individuals.
A Banking Example Banking Example
As financial intermediaries between the customer and the endeavor that it is looking to fund,s financial intermediaries between the customer and the endeavor that it is looking to fund,banks take in deposits on which they are obligated to pay interest (liabilities) and make loansanks take in deposits on which they are obligated to pay interest (liabilities) and make loans
on which they receive interest (assets). Besides loans, securities portfolios comprise then which they receive interest (assets). Besides loans, securities portfolios comprise the
assets of banks. Banks need to manage interest rate risk, which can lead to a mismatch of ssets of banks. Banks need to manage interest rate risk, which can lead to a mismatch of
assets and liabilities. Volatile interest rates and the abolition ofssets and liabilities. Volatile interest rates and the abolition of Regulation Qegulation Q, which capped which capped
the rate banks could pay depositors, both had a hand in this problem.he rate banks could pay depositors, both had a hand in this problem.
A bank’sbank’s net interest marginet interest margin – the difference between the rate that it pays on deposits and the difference between the rate that it pays on deposits and
the rate that it receives on its assets (loans and securities) – is a function ofhe rate that it receives on its assets (loans and securities) – is a function of interest ratenterest rate
sensitivityensitivity and the volume and mix of assets and liabilities. To the extent that a bank borrowsand the volume and mix of assets and liabilities. To the extent that a bank borrows
short term and lends long term, it has a mismatch that it needs to address throughhort term and lends long term, it has a mismatch that it needs to address through
restructuring of assets and liabilities or usingestructuring of assets and liabilities or using derivativeserivatives (swaps,(swaps, swaptionswaptions, options and options and
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futures) to satisfy the latter.utures) to satisfy the latter.
Insurance Examplesnsurance Examples
There are of two types of insurance companies: life and non-life (property and casualty). Lifehere are of two types of insurance companies: life and non-life (property and casualty). Life
insurers often have to meet a known liability with unknown timing in the form of a lumpnsurers often have to meet a known liability with unknown timing in the form of a lump
sum payout. Life insurers also offer annuities (reverse life insurance),um payout. Life insurers also offer annuities (reverse life insurance), that may be life orhat may be life or
non-life contingent, guaranteed rate accounts (GICs) and stable value funds.on-life contingent, guaranteed rate accounts (GICs) and stable value funds.
Withith annuitiesnnuities, liability requirement entails liability requirement entails
funding income for the duration of the annuity.unding income for the duration of the annuity.As tos to GICsICs and stable value products, they areand stable value products, they are
subject to interest rate risk, which can erodeubject to interest rate risk, which can erode
surplus and cause assets and liabilities to beurplus and cause assets and liabilities to be
mismatched. Liabilities of life insurers tend to beismatched. Liabilities of life insurers tend to be
longer duration. Accordingly, longer duration andonger duration. Accordingly, longer duration and
inflation protectednflation protected assets are selected to matchassets are selected to match
those of the liability (longer maturity bonds andhose of the liability (longer maturity bonds and
real estate, equity and venture capital), althougheal estate, equity and venture capital), although
product lines and their requirements vary.roduct lines and their requirements vary.
Non-life insurers have to meet liabilities (accident claims) of a much shorter duration, due toon-life insurers have to meet liabilities (accident claims) of a much shorter duration, due to
the typical three to five year underwriting cycle. The business cycle tends to drive thehe typical three to five year underwriting cycle. The business cycle tends to drive the
company’s need for liquidity. Interest rate risk is less of a consideration than for a lifeompany’s need for liquidity. Interest rate risk is less of a consideration than for a life
company. Liabilities tend to be uncertain as to both value and timing. The liability structureompany. Liabilities tend to be uncertain as to both value and timing. The liability structure
of such a company is a function of its product line and the claims and settlement process,f such a company is a function of its product line and the claims and settlement process,
which often are a function of the so-called “long tail” or period between the occurrence andhich often are a function of the so-called “long tail” or period between the occurrence and
claim reporting and the actual payout to the policyholder. This arises due to the fact thatlaim reporting and the actual payout to the policyholder. This arises due to the fact that
commercial clients make up a far larger portion of the total property and casualty marketommercial clients make up a far larger portion of the total property and casualty market
than they do in the life insurance business, which caters largely to individuals.han they do in the life insurance business, which caters largely to individuals.
The Benefit Plan Examplehe Benefit Plan Example
The traditional defined benefit plan has to satisfy a promise to pay the benefit formulahe traditional defined benefit plan has to satisfy a promise to pay the benefit formula
specified in the plan document of the plan sponsor. Accordingly, investment is long term inpecified in the plan document of the plan sponsor. Accordingly, investment is long term in
nature, with a view toward maintaining or growing the asset base and providing retirementature, with a view toward maintaining or growing the asset base and providing retirement
payments. In the practice known asayments. In the practice known as liability-driven investment (LDI)iability-driven investment (LDI), gauging the liability gauging the liability
entails estimating the duration of benefit payments and their present value.ntails estimating the duration of benefit payments and their present value.
Funding a benefit plan involves matching variable rate assets with variable rate liabilitiesunding a benefit plan involves matching variable rate assets with variable rate liabilities
(future retirement payments based upon salary growth projections of active workers) andfuture retirement payments based upon salary growth projections of active workers) and
fixed-rate assets with fixed-rate liabilities (income payments to retirees). As portfolios andixed-rate assets with fixed-rate liabilities (income payments to retirees). As portfolios and
liabilities are sensitive to interest rates, strategies such as portfolioiabilities are sensitive to interest rates, strategies such as portfolio immunizationmmunization andand
duration matching may be employed to protect them from rate fluctuations.uration matching may be employed to protect them from rate fluctuations.
Foundations and Non-Profitsoundations and Non-Profits
Institutions that make grants and are funded by gifts and investments are foundations.nstitutions that make grants and are funded by gifts and investments are foundations.
Endowments are long-term fundsndowments are long-term funds owned by non-profit organizations such as universities andowned by non-profit organizations such as universities and
hospitals; both tend to be perpetual in design. Their liability is an annual spendingospitals; both tend to be perpetual in design. Their liability is an annual spending
commitment as a percentage of the market value of assets, but may not be contractual,ommitment as a percentage of the market value of assets, but may not be contractual,
making them different from a defined benefit pension plan. The long-term nature of theseaking them different from a defined benefit pension plan. The long-term nature of these
arrangements often leads to a more aggressive investment allocation meant to outpacerrangements often leads to a more aggressive investment allocation meant to outpace
inflation, grow the portfolio and support and sustain a specific spending policy.nflation, grow the portfolio and support and sustain a specific spending policy.
Wealth Managementealth Management
With private wealthith private wealth, the nature of individuals’ liabilities may be as varied as the individualsthe nature of individuals’ liabilities may be as varied as the individuals
themselves. These run the gamut from retirement planning and education funding to homehemselves. These run the gamut from retirement planning and education funding to home
purchases and unique circumstances. Taxes and risk preferences will frame the asseturchases and unique circumstances. Taxes and risk preferences will frame the asset
allocation and risk management process that determines the appropriate asset allocation tollocation and risk management process that determines the appropriate asset allocation to
meet these liabilities. Techniques of asset/liability management can approximate those usedeet these liabilities. Techniques of asset/liability management can approximate those used
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8/17/2019 Examples Of Asset_Liability Management _ Investopedia.pdf
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1/18/2016 Examples Of Asset/Liability Manag ement | Investopedia
http://www.investopedia.com/articles/investing/041213/examples-assetliability-management.asp?no_header_alt=true
on an institutional level that considers multi-period horizons.n an institutional level that considers multi-period horizons.
Non-Financial Corporationson-Financial Corporations
Finally, non-financial corporations use asset/liability management techniques, of a sort, toinally, non-financial corporations use asset/liability management techniques, of a sort, to
hedge liquidity, foreign exchange, interest rate and commodity risk. An example of the latteredge liquidity, foreign exchange, interest rate and commodity risk. An example of the latter
would be an airline hould be an airline hedging its exposure to fluctuationsdging its exposure to fluctuations in fuel prices.n fuel prices.
The Bottom Linehe Bottom Line
Asset/liability management has become a complex endeavor. An understanding of internalsset/liability management has become a complex endeavor. An understanding of internal
and external factors that bear upon this aspect of risk management is critical to annd external factors that bear upon this aspect of risk management is critical to an
appropriate solution. Prudent asset allocation accounts not only for the growth of assets, butppropriate solution. Prudent asset allocation accounts not only for the growth of assets, but
also specifically addresses the nature of an organization’s liabilities.lso specifically addresses the nature of an organization’s liabilities.
OPTIONS & FUTURESPTIONS FUTURES
Managing Interest Rate Riskanaging Interest Rate RiskLearn which tools you need to manage the risk that comes with changingearn which tools you need to manage the risk that comes with changingrates.ates.
FOREX EDUCATIONOREX EDUCATION
Understanding Forex Risk Managementnderstanding Forex Risk ManagementThere's risk in every trade you take, but as long as you can measure risk, youhere's risk in every trade you take, but as long as you can measure risk, youcan manage it.an manage it.
RETIREMENTETIREMENT
The Evolution Of Enterprise Risk Managementhe Evolution Of Enterprise Risk ManagementThis growing sector can tell you a lot about the companies you are investinghis growing sector can tell you a lot about the companies you are investingin.n.
OPTIONS & FUTURESPTIONS FUTURES
Immunization Inoculates Against Interest Rate Riskmmunization Inoculates Against Interest Rate RiskBig-money investors can hedge against bond portfolio losses caused by rateig-money investors can hedge against bond portfolio losses caused by ratefluctuations.luctuations.
RETIREMENTETIREMENT
Mortgage Asset-Liability Management Made Easyortgage Asset-Liability Management Made EasyShould you refinance your mortgage to purchase other assets? Learn how tohould you refinance your mortgage to purchase other assets? Learn how toweigh your risk.eigh your risk.
INVESTING BASICSNVESTING BASICS
How Advisors Can Help Clients Stomach Volatilityow Advisors Can Help Clients Stomach VolatilityInvesting has its ups and downs, but financial advisers can do much tonvesting has its ups and downs, but financial advisers can do much toprepare their clients and their clients' portfolios for such volatility.repare their clients and their clients' portfolios for such volatility.
MUTUAL FUNDS & ETFSUTUAL FUNDS ETFS
(XME, PICK, GDX) 3 Bond ETFs in the Mining SectorXME, PICK, GDX) 3 Bond ETFs in the Mining Sector
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