Asset liability management (ACM) is a dynamic process of planning, organizing and controlling of assets and liabilities and their volumes.
Asset liability management can be defined as a mechanism to address the risk faced by a bank due to a mismatch between assets and liabilities either due to liquidity or changes in interest rates. Asset liability management is directly associated with risk management.
Thus, Asset liability management (ACM) process depends on:
- Measurement of gaps on the basis of maturity bucket
- Estimating the interest rate at which these funds will be reprised and projecting future interest income and interest expense.
- Exploring alternative interest rate scenarios
- Selecting the appropriate hedging tools to minimize the risk
Techniques of Asset liability Management
1. Forward Contract: Forward contract is the agreement between two parties to buy or sell a financial asset at a pre-determined price at a specific date in the future. A forward contract is a customized contract (not standardized) which means that the contract is agreed upon by the individual parties. Hence, it is traded Over the Counter (OTC).
The buyer of forwarding contract has the right and obligation to buy and the seller of forwarding contract has the right and obligation to sell as per the contract. The buyer of the contract takes a long position and seller of the contract takes a short position.
2. Future Contract: Future contract is similar to forward contract as an agreement between two parties to buy or sell a financial asset at a pre-determined price at a specific date in the future but a future contract is standardized. Hence, it is traded in Exchange market or organized market. The buyer of this contract takes a long position and seller of this contract takes a short position.
3. Options: The word “option” means that the holder has the right but not the obligation to buy/sell underlying assets. Options is a contract that gives the holder the option to buy/sell a specified quantity of the underlying assets at a particular price on or before a specified time period.
4. Interest rate swap: Interest rate swap is a contract between two parties to exchange interest payments in an effort to save money and hedge against interest rate risk. Interest rate swaps deal with asset-liability maturity mismatches, credit rating differences and foreign exchange.
5. Duration Gap management: Duration gap is the difference between the weighted average duration of the asset portfolio and weighted average duration of the liability portfolio. Duration gap simply gives information about which of the asset or liability is sensitive to change in interest rates. Mathematically, Duration Gap = (Weighted duration of asset portfolio—Weighted duration of liabilities portfolio)
6. Interest Sensitive Gap: Interest sensitive Gap refers to the difference between interest sensitive asset and interest-sensitive liabilities. Mathematically, Interest sensitive Gap (IS Gap) = (Interest Sensitive Assets (ISA) -Interest Sensitive Liabilities (ISL)).