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AN INTRODUCTION TO
BANKING
LIQUIDITY RISK AND
ASSET–LIABILITY MANAGEMENT
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AN
INTRODUCTION
TO BANKING
LIQUIDITY RISK AND
ASSET–LIABILITY MANAGEMENT
Moorad Choudhry
A John Wiley and Sons, Ltd, Publication

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For Mrs. Lindsay C houdhry
U ltimate yummy mummy
CONTENTS
Foreword x iii
Preface x ix
About the author x x iii
1 BANK BUSINESS AND CAPITAL 1
Bank ing bu sines s 2

Interest income 4
Fees and commissions 4
Trading income 4
C osts 5
Capital m ark ets 5
Scope of bank ing activ ities 8
C apital 9
Banking and trading books 10
Financial statem ents and ratios 13
The balance sheet 13
Profit and loss report 14
References 21
viii CONTENTS
2 THE MONEY MARKETS 23

Introdu ction 25
Secu rities qu oted on a y ield basis 27
Money market deposits 27
C ertificates of deposit 29
C D yields 30
Secu rities qu oted on a discou nt basis 34
Treasury bills 36
Banker’s acceptances 37
Eligible banker’s acceptance 38
Com m ercial paper 39
C ommercial paper programmes 40
C ommercial paper yields 42
Asset-backed commercial paper 43
Repo 48
D efinition 49
The classic repo 50
Examples of classic repo 52
The sell/buyback 56
Examples of sell/buyback 58
Repo collateral 60
Legal treatment 62
Margin 62
Variation margin 64
Cu rrencies u sing m oney m ark et y ear base of 365 day s 65
3 THE YIELD CURVE 67

Importance of the yield curve 68
U sing the yield curve 69
Yield-to-maturity yield curve 71
CONTENTS ix
Analysing and interpreting the yield curve 72

Theories of the yield curve 73
The zero-coupon yield curve 83
Example calculation illustrations 88
Forw ard rate calcu lation for m oney m ark et term 91
U nderstanding forward rates 92
Bibliography 93
4 INTRODUCTION TO TRADING AND HEDGING 95

Trading approach 96
The yield curve and interest rate expectations 96
C redit intermediation by the repo desk 98
Specials trading 100
Matched book trading 102
Interest-rate-hedging tools 103
Interest rate futures 103
Forward rate agreements 110
FRA mechanics 112
O vernight interest rate swaps 123
Credit risk hedging 129
U nderstanding credit risk 130
C redit rating rationale 133
C redit limit setting and rationale 135
Loan origination process standards 139
Bibliography 141
5 ASSET AND LIABILITY MANAGEMENT I 143

Basic concepts 144
Liquidity gap 147
Managing liquidity 153
x CONTENTS
The liquidity ratio 156

The liquidity portfolio 157
6 ASSET AND LIABILITY MANAGEMENT II 167

Introdu ction 168
Basic concepts 169
Interest rate risk and source 174
The bank ing book 180
The ALM desk 181
Traditional ALM 182
Dev elopm ents in ALM 184
Liqu idity and interest rate risk 185
The liquidity gap 185
G ap risk and limits 186
Liquidity management 192
Interest rate gap 194
Portfolio-modified duration gap 197
Critiqu e of the traditional approach 198
The cost of funding 199
Secu ritization 202
The securitization process 204
Benefits of securitization 206
G eneric ALM policy for different-sized banks 212
NPV and v alu e-at-risk 219
Bibliography 220
7 ASSET AND LIABILITY MANAGEMENT III:

THE ALCO 223
ALC O policy 224
ALC O reporting 227
CONTENTS xi
8 BANK LIQUIDITY RISK MANAGEMENT 233

The liquidity policy statement 234
Principles of bank liquidity risk management 241
Measuring bank liquidity risk: key metrics 244
Internal funding rate policy 252
C onclusion 259
9 A SUSTAINABLE BANK BUSINESS MODEL:

CAPITAL, LIQUIDITY AND LEVERAGE 261
The new bank business model 262
Liquidity risk management 271
The liquid asset buffer 276
C onclusions and recommendations 278
References 279
10 BANK REGULATORY CAPITAL 281

Banking regulatory capital requirements 282
C apital adequacy requirements 284
A primer on Basel II 285
Impact on specific sectors 289
Basel III 304
Bibliography 306
Appendix A Summary of bank product line 307

Appendix B Financial markets arithmetic 317
Appendix C List of abbreviations and acronyms 339
Index 343
FOREWORD
In m any w ay s, a handbook that helps to contex tu alize the bank ing

bu s iness as a portfolio of risk m anagem ent activ ities cou ld not be
m ore w elcom e or tim ely . It shou ld be no su rprise that the global-
ization of the fi nancial sy stem has dram atically ex panded the scope
of risk s a bank natu rally accu m u lates in its day -to-day operations.
Accordingly , the diffi cu lty of v alu ing and adm inistering these
aggregate risk s continu es to broaden. Whilst com pu ter technology
has at least prov ided the processing facu lty against this increasing
challenge, the bank ing indu stry is continu ally pressed to dev elop the
analy tical theory and hedging tools necessary to cope w ith risk
m anagem ent’s increasing com plex ity . The adv ent and rapid grow th
of m ark ets su ch as asset secu ritization and credit deriv ativ es, for
instance, ev idence su ch progress. Hence, any practical stu dy of
bank ing w ithou t a proper perspectiv e on the fu ndam ental liqu idity ,
capital, interest rate, , and credit risk m anagem ent techniqu es in
practice today w ou ld be incom plete.
With that said, the recent fi nancial crisis has raised m any qu estions
arou nd the m erits of the so-called ‘adv ances’ m ade in v alu ation and
risk theory ov er the past sev eral decades. I w ou ld argu e that ‘fi nan-
cial engineering’, as it has so du biou sly been labelled, has tak en a
disproportionate share of the blam e as the cataly st for the crisis. As
abov e, the genesis of these new tools and approaches has been born
ou t of necessity and are a natu ral consequ ence of the increasingly
com plex risk landscape for the fi nancial sy stem . So, althou gh con-
v enient, it w ou ld be an ov ersim plifi cation to su ggest that the tools of
fi nance by their ow n constru ction had cau sed the problem s ou tright.
More appropriately , one shou ld refl ect on how these fi nancial tools
w ere em ploy ed and w hy their natu ral lim itations w ere insu ffi ciently
appreciated. In retros pect, the latter is perhaps the m ain reason
m anagem ent at the m ost affected fi nancial institu tions did not
x iv FOREWORD
see the lev el of risk they w ere ex posed to u ntil it w as too late. Pu t
differently , as m easu res of risk ex posu re fi ltered u p throu gh these
organizations, the degree of sensitiv ity em bedded in those risk
m easu res w as lost in translation. In effect, the w orst hit fi nancial
institu tions ex perienced a failu re in risk m anagem ent. Risk m anage-
m ent, in this sense, refers not only to u nderstanding the v alu e of a
fi nancial asset at any giv en point in tim e bu t, m ore im portantly , the
sensitiv ity of its v alu e to rapidly changing m ark et conditions.
Stepping back , at the core of any tru e science is a set of basic
fu ndam ental principles and relationships that is accepted by all
researchers as a fou ndation to ex pand u pon. As a general m atter,
the science of fi nance is really no different. For m ost fi nancial assets
(bonds, equ ities, , real estate), the analy tical theory u sed to assess
their v alu e at any giv en m om ent is fairly dev eloped and is su pported
by broad consensu s. In fact, m any of those basic theories are captu red
in this book . If these theories are so generally accepted, one m ight
ask oneself: Why do any tw o parties ev er differ in term s of the v alu es
they w ou ld assign to any sim ilar asset? More concretely , in light of
the near death ex perience of the fi nancial sy stem , w hy had the v alu es
assigned to fi nancial assets by bu y ers and sellers (i.e., the ‘bid and
offer’) becom e v irtu ally irreconcilable. In short, v alu ation disparities
tend to be driv en m ore by div ergent v iew s on m odel inpu ts rather
than opposing analy tical approaches in them s elv es. This shou ld not
be too su rprising; the fi nancial indu stry pu rposefu lly look s to estab-
lish tools that are standardized and w idely shared. Pragm atically ,
standardization w ith open architectu re enhances transparency in an
asset class prom oting greater liqu idity and increased bu sines s
v olu m es.
Irrespectiv e of one’s tru st or distru st in cu rrent fi nancial theory , it is
hard to dispu te that the u se of poorly fou nded inpu t assu m ptions w ill
render ev en the best m odel ineffectiv e. As is the case w ith all
scientifi c m odels u s ed to predict and qu antify an ou tcom e, the
qu ality of the ou tpu t depends on the reliability of the inpu t. In
this regard, ex tracting dependable inference from historical sou rce
data is not a u niqu e challenge to the science of fi nance. Interpreting
historical sou rce data to v alidate forw ard assu m ptions is challenged
by sam pling inaccu racy , insu ffi cient tim e series, and reliance on
‘constant conditions’. ‘Constant conditions’, in this sense, refer to
the belief that ev ery factor that has infl u enced historical sou rce
data w ill rem ain the sam e in the fu tu re as w ill its im pact. Unlik e
theoretical science, thou gh, fi nancial m ark ets do not ex ist in a
controlled env ironm ent or v acu u m . On the contrary , fi nancial
FOREWORD xv
m ark ets are highly dy nam ic and interconnected. Thu s, historical

data are not necessarily predictiv e of fu tu re actu al ou tcom es
neither in term s of av erage ex pectation nor the v ariance arou nd
that ex pectation. This brings one back again to the concept of
fi nancial risk m anagem ent, w hereby fi nancial risk m anagem ent
look s to m etric the im pact that changing conditions hav e on the
base assu m ptions behind v alu ation tools (i.e., the 2nd, 3rd, , nth
order effects that changing m ark et env ironm ents hav e on v alu ation
ou tcom es). Not su rprisingly , fram ing asset v alu ation sensitiv ity to
captu re the im pact of changing conditions has only gotten m ore
challenging in a globalizing fi nancial w orld. Globalization by
its v ery natu re is a ‘non-constant condition’ that creates greater
v olatility in the reliability of forw ard assu m ptions relativ e to
historical ex perience.
With that back grou nd, the stru ctu ral lim itations inherent in m ak ing
forw ard predictions based on m odels w ere ex em plifi ed early in the
crisis m ost notably w ith m ortgage-back ed secu rities. For m any
y ears, the cu m u lativ e borrow er defau lt rates assu m ed to v alu e
those secu rities relied heav ily , am ong other things , on back w ard-
look ing observ ation. With the benefi t of hindsight, these assu m p-
tions considerably u nderestim ated the actu al defau lt rates cu rrently
being realized today . In other w ords, the tru e v alu e of the cash fl ow s
from these secu rities w as ov erestim ated and the price paid for those
secu rities at inception w as too high. As the lik elihood for w orsening
defau lt rates transpired, inv estors reran their m odels u sing the
m ore lik ely ex pectation only to learn that their inv estm ents w ere
w orth considerably less in m any cases. The realization that so m any
cou ld be so w rong created a crisis of confi dence that u ltim ately pu t
the entire fi nancial sy stem in disarray . It triggered qu estions by
originators, inv estors, rating agencies and regu lators as to the accu -
racy of all assu m ptions and m odels being u sed to determ inistically
set prices. This one ev ent placed the entire fi nancial indu stry into
the lim elight and onto its back foot.
So, w hy w ere the actu al defau lt rates being observ ed today not in the
realm of im aginable possibility w hen com pared w ith those actu ally
u sed to popu late the v alu ation m odels ? Was it really the science of
fi nance (i.e., ‘fi nancial engineering’ ) in itself that cau sed the ov er-
sight? Well, as abov e, the ov erreliance on historical data to predict
fu tu re ou tcom es had the m ost obv iou s role. In ou r m ortgage-back ed
secu rities ex am ple, w hat m any failed to appreciate w as that lender
u nderw riting standards had changed signifi cantly . As a consequ ence,
the historical sou rce data u sed to su pport m odel inpu ts w ere no
x vi FOREWORD
longer relev ant. Said differently , the ‘constant condition’ betw een
past and fu tu re w as erroneou sly u nqu estioned. Interestingly ,
thou gh, for those that inv ested in those m ortgage-back ed secu rities
the consensu s v iew on v alu e betw een seller and bu y er w as v ery
sim ilar pre crisis. This w as ev idenced em pirically by the v ery
tight ‘bid–offer’ prices on those secu rities before the m ark et m elt-
dow n. The ‘bid–offer’ can be v iew ed as a prox y m easu re of how in
agreem ent bu y ers and sellers are on the inpu ts being u sed in their
v alu ation m odels. Bu t w e k now from hindsight, certain m ark et
participants av oided tak ing ex posu re to this asset class . Others
w ent as far as to tak e deliberate v iew s that the consensu s v alu es
w ere so su ffi ciently ov erstated that they ex ercised their v iew s by
selling those secu rities short. Thes e contrarians, despite being
lim ited to the sam e tools and sam e historical data as any one else,
w ere u ltim ately correct in their div ergent v iew s. Were they sim ply
sm arter?
More realistically , they w ere not sm arter. I w ou ld argu e that they
w ere ju st better at u nderstanding the lim itations and risk s in rely ing
on m odels and historical sou rce data. Perhaps im portantly , they
look ed to factors ou tside the u su al nu m eric sou rces of inform ation
and applied ju dgm ent to stres s their m odel assu m ptions bey ond the
historical ex perience. Thes e ‘risk m anagers’ w ere m ore enlightened
only to the ex tent that they recognized that the ‘constant condition’
w as no longer v alid. Basic qu estions arou nd ex ponential origination
grow th, deteriorating dem ographics, increased u se of teaser rates,
high loan to v alu es and docu m entation (i.e., all w idely discu s sed
in the pu blic dom ain), shou ld hav e giv en rise to refl ection for all
inv olv ed to qu estion fu rther w hether the m odel inpu ts and hence
m odel ou tpu ts m ade sense? In the end, no m odel can replace basic
ju dgm ent, intu ition or com m on sense. Perhaps this is the com m on
sense lesson?
Althou gh it is rare for fi nance book s to be philosophical, hopefu lly ,
som e of the v iew points abov e w ill help to pu t perspectiv e arou nd the
pow ers and pitfalls of fi nancial science. As w ith all sciences, the
theoretical fram ew ork s, the analy tical m odels, and the instru m ents
them s elv es (i.e., ‘collectiv e fi nancial technology ’) are only tools –
their predictions and prom ises are not absolu tes. While ‘collectiv e
fi nancial technology ’ allow s for better u nderstanding of v alu ation
basics, m ore practically , their u tility is best w hen considered as part
of the broad su ite of tools av ailable to su pport decisions arou nd
‘fi nancial risk m anagem ent’ . Upon refl ection, perhaps the better
nom enclatu re is ‘fi nancial risk ju dgm ent’. At least u nder this
FOREWORD x vii
description, it m arries both science and hu m an intu ition. Hu m an

intu ition in this respect refers to ou r u niqu e ability to qu estion w hat
w e observ e or w hat w e are told; for ex am ple, are ou r data sou rces and
assu m ptions reasonable? Fu rtherm ore, it refers to ou r u niqu e ability
to indiv idu ally asses s and w eigh an ex pected fi nancial resu lt v ersu s
the consequ ences of an u nex pected bad resu lt: Can w e liv e w ith the
dow nside scenario if ou r assu m ptions are inv alid? The long-ru n bu ll
m ark et leading u p to the fi nancial crisis clou ded hu m an ju dgm ent
arou nd dow nside risk aw areness for m any . The senior m anagem ent
at m any fi nancial institu tions becam e obsessed w ith absolu te
rev enu es rather than risk -adju sted rev enu es. Consequ ently , m any
of the new er fi nancial tools and innov ations w ere u s ed for specu la-
tion rather than for the pu rposes they w ere dev eloped – su ch as risk
im m u nization. Unfortu nately , this behav iou ral trait is endem ic of
the hu m an condition and recu rring throu ghou t history . Technology
doesn’t m ak e decisions, hu m ans do.
Lik e all technology , the tools of fi nance hav e the facu lty to be u sed
appropriately and inappropriately . Albeit, this is not to be confu sed
w ith the notion that they are either ‘good’ or ‘bad’ as som e w ou ld lik e
to argu e. Wrongly , su ch ov ersim plifi cations are often u sed to ju stify
or discredit the u tility of other science fi elds (i.e., nu clear energy ,
genetics and social planning). Thank fu lly , the w orld w e liv e in is not
that sim ple or binary . With that said, there is perhaps one absolu te
that m ost w ou ld agree u pon. There is an u nw ritten du ty that
transcends all science practitioners: u s e the tools and k now ledge
conscientiou sly . As new and old stu dents of fi nance stu dy this
tex t, it is incu m bent u pon y ou to appreciate the strengths and
w eak nesses of the discipline and transact responsibly w ithin its
bou ndaries.
Oldrich Masek
Managing Director, JPMorgan
PREFACE
Bank ing is a long-established and honou rable profession. The

prov ision of effi cient loan and deposit facilities is an essential
ingredient in hu m an dev elopm ent and prosperity . For this reason,
it is im portant that all bank s are m anaged pru dently . The art of
bank ing rem ains u nchanged from w hen bank s w ere fi rst established.
At its core are the tw o principles of asset–liability m ism atch and
liqu idity risk m anagem ent. The act of u ndertak ing loans and
deposits creates the m ism atch, becau se w hile inv estors lik e to
lend for as short a term as possible, borrow ers prefer to borrow for
as long a term as possible. In other w ords, the act of bank ing is the
process of maturity transformation, w hereby bank s ‘lend long’ and
‘fu nd short’. Bank s do not ‘m atch-fu nd’, becau se there w ou ld nev er
be enou gh fu nds av ailable to m atch a 25-y ear m atu rity m ortgage
w ith a 25-y ear fi x ed deposit. Thu s, bank ing giv es rise to liqu idity
risk , and bank ers are therefore requ ired to tak e steps to ensu re that
liqu idity , the ability to roll ov er fu nding of long-dated loans, is
continu ou sly av ailable.
We defi ne bank ing as the prov ision of loans and deposits; the form er
produ ce interest incom e for the bank , w hile the latter create interest
ex pense for the bank . On the bank ’s balance sheet the loan is the
asset and the deposit is the liability , and the bank acts as the inter-
m ediary betw een borrow ers and lenders . The fact that all bank s
irrespectiv e of their size, approach or strategy m u st m anage the
tw o basic principles of asset–liability m anagem ent (ALM) and liqu id-
ity m anagem ent m eans that they are u ltim ately identical institu -
tions. They deal w ithin the sam e m ark ets and w ith each other. That
m eans that the bank ru ptcy of any one bank , w hile seriou s for its
cu stom ers and creditors, can hav e a bigger im pact still on the w ider
econom y becau se of the risk this poses to other bank s. It is this
sy stem ic risk w hich posed the danger for the w orld’s econom ies
xx PREFACE
in 2008, after Lehm an Brothers collapsed, and w hich rem ains a

challenge for fi nancial regu lators.
This book introdu ces the fu ndam ental art of bank ing, w hich is ALM
and liqu idity risk m anagem ent. It does not describe the different
ty pes of bank s and their organizational stru ctu res that ex ist arou nd
the w orld. Neither does it describe the w ide range of bank produ cts
that are av ailable or the great v ariation in fi nancial m ark ets and
instru m ents that can be observ ed. Thes e topics are cov ered abu n-
dantly in ex isting tex tbook s. The object of this book is to present
bank ALM and liqu idity m anagem ent at an introdu ctory lev el, som e-
thing that is not so com m on in tex tbook s on fi nance. Thes e topics
deserv e to be u nderstood and appreciated by ev ery one inv olv ed in
bank ing, becau se it w as u nsou nd practices in these fi elds that helped
to create the bank ing crisis in 2008, and m ade its im pact so m u ch
w orse than it need hav e been. A proper respect for the art of ALM w ill
m itigate the im pact on bank s of the nex t fi nancial crash.
Lay out of the book

This book com prises 10 chapters. The fi rst fou r prov ide a necessary
back grou nd on bank capital, the m oney m ark ets, the y ield cu rv e and
m ark et risk hedging. This is essential reading for all new com ers to
the fi nancial m ark ets. Chapters 5–7 discu s s the asset–liability
m anagem ent (ALM) process for a bank – the essential art of
bank ing – and the role of the ALM com m ittee or ALCO, w hich is
the m ost im portant ex ecu tiv e m anagem ent com m ittee in a bank .
Chapter 8 tak es a detailed look at liqu idity risk m anagem ent, w hile
Chapter 9 focu ses on bank strategy and retu rn. The fi nal chapter
look s at regu latory capital, the av ailability and treatm ent of w hich
driv es bank strategy .
For new com ers to the m ark et there is a prim er on fi nancial m ark et
arithm etic in Appendix B (p. 317).
Highlights of the book inclu de
an accessible look at the ALM fu nction u ndertak en at bank s and
secu rities hou ses, inclu ding risk m anagem ent and m anagem ent
reporting;
the role of the bank ALM com m ittee (ALCO);
a rev iew of liqu idity risk m anagem ent and the m ain liqu idity
m etrics u sed in bank s;
PREFACE xxi
a discu s sion of bank strategy and w hy this shou ld focu s on

su stainable retu rns ov er the bu sines s cy cle;
an introdu ction to the Basel II and Basel III regu latory capital
ru les and their im plications.
As alw ay s, the intention is to rem ain accessible and practical

throu ghou t, and w e hope this aim has been achiev ed. Com m ents
on the tex t are m ost w elcom e and shou ld be sent to the au thor, care
of John Wiley & Sons (UK) Ltd.
Ack now ledgem ents

Thank s to Adrian Bu ck ley , Khu rram Bu tt, George Ev ans, Sean
Jay asek ara, Grant Jenk ins on, Gino Landu y t, Sharon Mandev ille,
Neil McDou gall, Ek aterina Mihov a, Lam iaa Moham m ed, Frank
Stoltz, Stu art Tu rner, Dianne Weston, the chaps in the Post
Room , and Graem e Wolv aardt for their help du ring the tim e I w as
at Eu rope Arab Bank ; and to Roger Dray ton, Tope Fasu a, Marty n
Hoccom , Adam Law son, Stu art Medlen, Abhijit Pathark ar, Bill
Rick ard and Frank Spiteri for their help after I left there.
Thank s to The Raynes Park Footy Boys. A Solid Bond in You r Heart.
Moorad Choudhry
Su rrey , England
2 October 2010
ABOUT THE AUTHOR
Moorad Choudhry is Managing Director, Head of Bu s iness Treasu ry ,
Global Bank ing and Mark ets at The Roy al Bank of Scotland. He w as
prev iou sly Head of Treasu ry at Eu rope Arab Bank , Head of Treasu ry
at KBC Financial Produ cts and Vice President in Stru ctu red Finance
Serv ices at JPMorgan Chase Bank .
Dr. Chou dhry is Visiting Profes sor at the Departm ent of Econom ics ,
London Metropolitan Univ ersity ; Visiting Research Fellow at the
ICMA Centre, Univ ersity of Reading; Associate Research Fellow at
the School of Inform ation Sy stem s, Com pu ting and Mathem atics ,
Bru nel Univ ersity ; Visiting Teaching Fellow at the Departm ent of
Managem ent, Birk beck , Univ ersity of London; a Fellow of the
Chartered Institu te for Secu rities & Inv estm ent; a Fellow of the
ifs-School of Finance; a Fellow of the Global Ass ociation of Risk
Professionals; a Fellow of the Institu te of Sales and Mark eting
Managem ent; and a Fellow of the Institu te of Directors. He is on
the editorial boards of Q ualitative Research in Financial Markets,
Securities & Investment Review and the Journal of Structured
Finance and on the adv isory board of the American Securitization
Forum.
H e critically failed to delegate or appoint talented people lest
they might undermine his overall authority. Instead he promoted
those whose weaknesses he understood and could exploit.
C ompetence was not an issue.
– Jam es Wy llie, G oering and G oering: H itler’s H enchman and
H is Anti-N azi Brother, The His tory Press, 2006
An Introduction to Banking: Liquidity Risk and Asset–Liability Management
By Moorad Choudhry
Copyright © 2011 Moorad Choudhry.
Chapter
1
BANK BUSINESS
AND CAPITAL
2 AN INTRODUCTION TO BANKING
B ank ing has a long and honou rable history . Today it encom passes
a w ide range of activ ities of v ary ing degrees of com plex ity .
Whatev er the precis e bu s iness, the com m on denom inators of all
bank ing activ ities are those of risk , retu rn and the bringing together
of the prov iders of capital. Retu rn on capital is the focu s of all
bank ing activ ity . The co-ordination of all bank ing activ ity cou ld
be said to be the focu s of asset–liability m anagem ent (ALM),
althou gh som e practitioners w ill giv e ALM a narrow er focu s.
Either w ay , w e need to be fam iliar w ith the w ide-ranging natu re
of bank ing bu sines s and the im portance of bank capital. This then
acts as a gu ide for w hat follow s.
In this introdu ctory chapter w e place ALM in contex t by describing
the fi nancial m ark ets and the concept of bank capital. We begin w ith
a look at the bu sines s of bank ing. We then consider the different
ty pes of rev enu e generated by a bank , the concept of the bank ing
book and the trading book , fi nancial statem ents and the concept of
prov isions.
BANKING BUSINESS
Bank ing operations encom pas s a w ide range of activ ities, all of w hich
contribu te to the asset and liability profi le of a bank . Table 1.1 show s
selected bank ing activ ities and the ty pe of risk ex posu re they repre-
sent. The term s u sed in the table, su ch as ‘m ark et risk ’, are ex plained
elsew here in this book . In another chapter w e discu s s the elem entary
aspects of fi nancial analy sis – u sing k ey fi nancial ratios – that are
u sed to ex am ine the profi tability and asset qu ality of a bank . We also
discu s s bank regu lation and the concept of bank capital.
Before considering the concept of ALM, all readers shou ld be fam iliar
w ith the w ay a bank ’s earnings and perform ance are reported in its
fi nancial statem ents . A bank ’s incom e statem ent w ill break dow n
earnings by ty pe, as w e hav e defi ned in Table 1.1. So w e need to be
fam iliar w ith interest incom e, trading incom e and so on. The other
side of an incom e statem ent is costs, su ch as operating ex penses and
bad loan prov isions.
That the u niv ers e of bank s encom pas ses m any different v arieties of
beasts is ev ident from the w ay they earn their m oney . Traditional
bank ing institu tions, perhaps ty pifi ed by a regional bank in the
United States (US) or a bu ilding society in the United Kingdom
(UK), w ill generate a m u ch greater share of their rev enu es throu gh
BANK BUSINESS AND CAPITAL 3
Table 1.1 Selected bank ing activ ities and serv ices
Service or function Revenue generated Risk
Lending
– Retail Interest incom e, fees Credit, m ark et
– Com m ercial Interest incom e, fees Credit, m ark et
– Mortgage Interest incom e, fees Credit, m ark et
– Sy ndicated Trading, interest Credit, m ark et
incom e, fees
Credit cards Interest incom e, fees Credit, operational
Project fi nance Interest incom e, fees Credit
Trade fi nance Interest incom e, fees Credit, operational
Cash m anagem ent
– Processing Fees Operational
– Pay m ents Fees Credit, operational
Cu stodian Fees Credit, operational
Priv ate bank ing Com m ission incom e, Operational
interest incom e,
fees
Asset m anagem ent Fees, perform ance Credit, m ark et, operational
pay m ents
Capital m ark ets
– Inv estm ent bank ing Fees Credit, m ark et
– Corporate fi nance Fees Credit, m ark et
– Equ ities Trading incom e, fees Credit, m ark et
– Bonds Trading incom e, Credit, m ark et
interest incom e,
fees
– Foreign ex change Trading incom e, fees Credit, m ark et
– Deriv ativ es Trading incom e, Credit, m ark et
interest incom e,
fees
net interest incom e than trading incom e, and v ice v ersa for a fi rm
w ith an inv estm ent bank heritage su ch as Morgan Stanley . Su ch
fi rm s w ill earn a greater share of their rev enu es throu gh fees and
trading incom e. The break dow n v aries w idely across regions and
bank s.
Let u s now consider the different ty pes of incom e stream s and costs.
Interest incom e
Interest incom e, or net interest incom e (NII), is the m ain sou rce of
rev enu e for the m ajority of bank s w orldw ide. It can form u pw ards of
60% of operating incom e, and for sm aller bank s and bu ilding
societies it reaches 80% or m ore.
NII is generated from lending activ ity and interest-bearing assets,
‘net’ retu rn is this interest incom e m inu s the cost of fu nding loans.
Fu nding, w hich is a cost to the bank , is obtained from a w ide v ariety
of sou rces. For m any bank s, deposits are a k ey sou rce of fu nding, as
w ell as one of the cheapest. They are generally short term , thou gh, or
av ailable on dem and, so m u st be su pplem ented by longer term
fu nding. Other sou rces of fu nds inclu de senior debt, in the form
of bonds , secu ritized bonds and m oney m ark et paper.
NII is sensitiv e to both credit risk and m ark et risk . Mark et risk ,
w hich w e look at later, is essentially interest rate risk for loans and
deposits. Interest rate risk w ill be driv en by the m atu rity stru ctu re of
the loan book , as w ell as the m atch (or m ism atch) betw een the
m atu rity of loans against the m atu rity of fu nding. This is k now n
as the interest rate gap.
Fees and com m issions

Bank s generate fee incom e as a resu lt of prov iding serv ices to
cu stom ers. Fee incom e is v ery popu lar w ith bank senior m anage-
m ent becau se it is less v olatile and not su sceptible to m ark et risk
lik e trading incom e or ev en NII. There is also no credit risk becau se
fees are often paid u pfront. There are other benefi ts as w ell, su ch as
the opportu nity to bu ild u p a div ersifi ed cu stom er base for this
additional range of serv ices, bu t these are of less concern to a
bank ’s ALM desk .
Fee incom e u ses less capital and also carries no m ark et risk , bu t does
carry other risk s, su ch as operational risk .
Trading incom e
Bank s generate trading incom e throu gh trading activ ity in fi nancial
produ cts su ch as equ ities (shares), bonds and deriv ativ e instru m ents .
This inclu des acting as a dealer or m ark et-m ak er in these produ cts as
w ell as tak ing proprietary positions for specu lativ e pu rposes.
Ru nning positions in secu rities (as opposed to deriv ativ es) in som e
cases generates interest incom e; som e bank s strip this ou t of the
capital gain m ade w hen the secu rity is traded to profi t, w hile others
inclu de it as part of ov erall trading incom e.
Trading incom e is the m ost v olatile incom e sou rce for a bank . It also
generates relativ ely high m ark et risk , as w ell as not inconsiderable
credit risk . Many bank s, althou gh by no m eans all, u se the Valu e-at-
Risk (VaR) m ethodology to m easu re the risk arising from trading
activ ity , w hich giv es a statistic al m easu re of ex pected losses to the
trading portfolio u nder certain m ark et scenarios.
Costs
Bank operating costs com prise staff costs and operating costs, su ch as
prov ision of prem ises, inform ation technology and offi ce equ ipm ent.
Other signifi cant elem ents of cost are prov isions for loan losses,
w hich are charges against the loan rev enu es of the bank . Prov ision
is based on su bjectiv e m easu rem ent by m anagem ent of how m u ch of
the loan portfolio can be ex pected to be repaid by the borrow er.
CAPITAL MARKETS
A ‘capital m ark et’ is the term u sed to describe the m ark et for raising
and inv esting fi nance. The econom ies of dev eloped cou ntries and a
large nu m ber of dev eloping cou ntries are based on fi nancial sy stem s
that encom pas s inv estors and borrow ers, markets and trading
arrangem ents. A m ark et can be one in the traditional sense su ch
as an ex change w here financial instruments are bou ght and sold on a
trading fl oor, or it m ay refer to one w here participants deal w ith each
other ov er the telephone or v ia electronic screens. The basic prin-
ciples are the sam e in any ty pe of m ark et. There are tw o prim ary
u sers of capital m ark ets: lenders and borrow ers. The sou rce of
lenders’ fu nds is, to a large ex tent, the personal sector m ade u p of
hou s ehold sav ings and those acting as their inv estm ent m anagers
su ch as life assu rance com panies and pension fu nds. The borrow ers
are m ade u p of the gov ernm ent, local gov ernm ent and com panies
(called corporates). There is a basic confl ict betw een the fi nancial
objectiv es of borrow ers and lenders , in that those w ho are inv esting
fu nds w ish to rem ain liquid, w hich m eans hav ing easy access to
their inv estm ents . They also w is h to m ax im ize the retu rn on their
inv estm ent. A corporate, on the other hand, w ill w ish to generate
m ax im u m net profi t on its activ ities, w hich w ill requ ire continu ou s
inv estm ent in plant, equ ipm ent, hu m an resou rces and so on.
Su ch inv estm ent w ill therefore need to be as long term as possible.
Gov ernm ent borrow ing as w ell is often related to long-term projects
su ch as the constru ction of schools, hospitals and roads. So w hile
inv estors w is h to hav e ready access to their cash and inv est short,
borrow ers desire fu nding to be as long term as possible. One econ-
om is t referred to this confl ict as the ‘constitu tional w eak ness’ of
fi nancial m ark ets (Hick s, 1939), especially as there is no condu it
throu gh w hich to reconcile the needs of lenders and borrow ers. To
facilitate the effi cient operation of fi nancial m ark ets and the price
m echanism , interm ediaries ex ist to bring together the needs of
lenders and borrow ers. A bank is the best ex am ple of this. Bank s
accept deposits from inv estors, w hich m ak es u p the liability side of
their balance sheet, and lend fu nds to borrow ers, w hich form s the
assets on their balance sheet. If a bank bu ilds u p a su ffi c iently large
asset and liability base, it w ill be able to m eet the needs of both
inv estors and borrow ers, as it can m aintain liqu idity to m eet
inv estors requ irem ents as w ell as create long-term assets to m eet
the needs of borrow ers. A bank is ex posed to tw o prim ary risk s in
carry ing ou t its operations: that a large nu m ber of inv estors decide to
w ithdraw their fu nds at the sam e tim e (a ‘ru n’ on the bank ) or that a
large nu m ber of borrow ers go bank ru pt and defau lt on their loans.
The bank in acting as a fi nancial interm ediary redu ces the risk it is
ex posed to by spreading and pooling risk across a w ide asset and
liability base.
Corporate borrow ers w is hing to fi nance long-term inv estm ent can
raise capital in v ariou s w ay s. The m ain m ethods are
continu ed re-inv estm ent of the profi ts generated by a com pany ’s
cu rrent operations;
selling shares in the com pany , k now n as equ ity capital, equ ity
secu rities or equity, w hich confer on bu y ers a share in ow ners hip
of the com pany . Shareholders as ow ners hav e the right to v ote at
general m eetings of the com pany , as w ell as the right to share in
the com pany ’s profi ts by receiv ing div idends;
borrow ing m oney from a bank , v ia a bank loan. This can be a
short-term loan su ch as an ov erdraft, or a longer term loan ov er
tw o, three, fi v e y ears or ev en longer. Bank loans can be at either a
fi x ed or, m ore u su ally , v ariable rate of interest;
borrow ing m oney by issu ing debt secu rities, in the form of bills,
commercial paper and bonds that su bsequ ently trade in the debt
capital m ark et.
The fi rst m ethod m ay not generate su ffi cient fu nds, especially if a

com pany is seek ing to ex pand by grow th or acqu isition of other
com panies. In any case a proportion of annu al after-tax profi ts
w ill need to be paid ou t as div idends to shareholders. Selling
fu rther shares is not alw ay s popu lar am ongst ex isting shareholders
as it dilu tes the ex tent of their ow ners hip; m oreov er, there are a host
of other factors to consider inclu ding w hether there is any appetite in
the m ark et for that com pany ’s shares . A bank loan is often infl ex ible,
and the interest rate charged by the bank m ay be com parativ ely high
for all bu t the highest qu ality com panies. We say ‘com parativ ely ’ ,
becau se there is often a cheaper w ay for corporates to borrow m oney :
by tapping the bond m ark ets. An issu e of bonds w ill fi x the rate of
interest pay able by the com pany for a long-term period, and the chief
characteristic of bonds – that they are tradeable – m ak es inv estors
m ore w illing to lend a com pany fu nds.
The bond and m oney m ark ets play a v ital and essential role in raising
fi nance for both gov ernm ents and corporations. In 2009 the m ark et
in dollar-denom inated bonds alone w as w orth ov er $13 trillion,
w hich giv es som e idea of its im portance. The basic bond instru m ent,
w hich is a loan of fu nds by the bu y er to the issu er of the bond, in
retu rn for regu lar interest pay m ents u p to the term ination date of the
loan, is still the m ost com m only issu ed instru m ent in debt m ark ets.
Now aday s there are a large v ariety of bond instru m ents, issu ed by a
v ariety of institu tions . An alm os t ex clu siv ely corporate instru m ent,
the international bond or Eu robond, is a large and div erse m ark et.
In 2009 the size of the Eu robond m ark et w as ov er $2 trillion.
In ev ery capital m ark et the fi rst fi nancing instru m ent ev er dev eloped
w as the bill and then the bond; today , in certain dev eloping
econom ies the gov ernm ent short-dated bond m ark et is often the
only liqu id m ark et in ex istence. Ov er tim e – as fi nancial sy stem s
dev elop and corporate debt and equ ity m ark ets tak e shape – the
m oney and bond m ark ets retain their im portance du e to their fl ex -
ibility and the ease w ith w hich transactions can be u ndertak en. In
adv anced fi nancial m ark ets – su ch as those in place in dev eloped
cou ntries today – the introdu ction of financial engineering tech-
niqu es has greatly ex panded the range of instru m ents that can be
traded. Thes e instru m ents inclu de instru m ents u sed for hedging
positions held in bonds and other cash produ cts, as w ell as
m eeting the inv estm ent and risk management needs of a w hole
hos t of m ark et participants. Debt capital m ark ets hav e been and
continu e to be trem endou sly im portant to the econom ic dev elop-
m ent of all cou ntries, as they represent the m eans of intermediation
for gov ernm ents and corporates to fi nance their activ ities. In fact, it
is diffi cu lt to im agine long-term capital-intensiv e projects – su ch as
those u ndertak en by , say , petroleu m , constru ction or aerospace com -
panies – tak ing place w ithou t the ex istence of a debt capital m ark et
to allow the raising of v ital fi nance.
SCOPE OF BANKING ACTIVITIES

We hav e introdu ced the different aspects of bank ing bu sines s. For the
largest bank s these aspects v ary w idely in natu re. For ou r pu rposes
w e m ay grou p them together as show n at Figu re 1.1. Pu t v ery sim ply ,
‘retail’ or ‘com m ercial’ bank ing cov ers the m ore traditional lending
and tru st activ ities w hile ‘inv estm ent’ bank ing cov ers trading activ -
ity and fee-based incom e su ch as stock ex change listing and m ergers
and acqu isitions . The one com m on objectiv e of all bank ing activ ity
is retu rn on capital. Depending on the degree of risk it represents, a
particu lar activ ity w ill be requ ired to achiev e a specifi ed retu rn on
the capital it u ses. The issu e of bank ing capital is v ital to an apprecia-
Figure 1.1 Scope of bank ing activ ities.

tion of the bank ing bu sines s; entire new bu sines s lines (su ch as
secu ritization) hav e been dev ised in response to the need to m ak e
the u se of capital m ore effi cient.
As w e can see from Figu re 1.1, the scope of bank ing bu sines s is w ide.
Activ ities range from essentially plain v anilla activ ity , su ch as cor-
porate lending, to com plex transactions su ch as secu ritization and
hy brid produ ct trading. There is a v ast literatu re on all these activ -
ities, so w e do not need to cov er them here. How ev er, it is im portant
to hav e a grou nding in the basic produ cts; su bsequ ent chapters w ill
introdu ce these.
ALM is concerned w ith the effi cient m anagem ent of bank ing capital
am ong other things . It therefore concerns itself w ith all bank ing
operations, ev en if day -to-day contact betw een the ALM desk (or
Treasu ry desk ) and other parts of the bank is rem ote. The ALM desk
w ill be responsible for the Treasu ry and m oney m ark et activ ities of
the entire bank . So, if w e w ish, w e cou ld draw a box w ith ALM in it
arou nd the w hole of Figu re 1.1. This is not to say that the ALM
fu nction does all these activ ities; rather, it is ju st to m ak e clear that
all the v ariou s activ ities represent assets and liabilities for the bank ,
and one central fu nction is responsible for this side of these activ -
ities.
For capital m anagem ent pu rposes a bank ’s bu s iness is organized into
a ‘bank ing book ’ and a ‘trading book ’ . We consider them nex t; fi rst
thou gh, a w ord on bank capital.
Capital
Bank capital is the equ ity of the bank . It is im portant as it is the
cu shion that absorbs any u nreserv ed losses that the bank incu rs . By
acting as this cu shion, it enables the bank to continu e operating and
thu s av oid insolv ency or bank ru ptcy du ring periods of m ark et correc-
tion or econom ic dow ntu rn. When the bank su ffers a loss or w rites
off a loss-m ak ing or otherw ise econom ically u ntenable activ ity , the
capital is u sed to absorb the loss. This can be done by eating into
reserv es, freezing div idend pay m ents or (in m ore ex trem e scenarios)
a w ritedow n of equ ity capital. In the capital stru ctu re, the rights of
capital creditors inclu ding equ ity holders are su bordinated to senior
creditors and deposit holders.
Bank s occu py a v ital and piv otal position in any econom y , as the
su ppliers of credit and fi nancial liqu idity , so bank capital is
im portant. As su ch, bank s are heav ily regu lated by central m onetary
au thorities , and their capital is su bject to regu latory ru les com piled
by the Bank for International Settlem ents (BIS), based in Basel,
Sw itzerland. For this reason its regu latory capital ru les are often
called the ‘Basel ru les ’. Under the original Basel ru les (Basel I) a
bank ing institu tion w as requ ired to hold a m inim u m capital lev el
of 8% against the assets on its book . 1 Total capital is com prised of
equ ity capital;
reserv es;
retained earnings;
preference share issu e proceeds;
hy brid capital instru m ents;
su bordinated debt.
Capital is split into Tier 1 capital and Tier 2 capital. The fi rst three
item s in the bu llet list com prise Tier 1 capital w hile the rem aining
item s are Tier 2 capital.
The qu ality of the capital in a bank refl ects its m ix of Tier 1 and Tier 2
capital. Tier 1 or ‘core capital’ is the highest qu ality capital, as it is
not obliged to be repaid; m oreov er, there is no im pact on the bank ’s
repu tation if it is not repaid. Tier 2 is considered low er qu ality as it is
not ‘los s absorbing’; it is repay able and also of shorter term than
equ ity capital. Assessing the fi nancial strength and qu ality of a
particu lar bank ing institu tion often requ ires calcu lating k ey
capital ratios for the bank and com paring them w ith m ark et av erages
and other benchm ark s .
Analy sts u se a nu m ber of ratios to asses s bank capital strength. Som e
of the m ore com m on ones are show n in Table 1.2.
Bank ing and trading book s

Bank s and fi nancial institu tions m ak e a distinction betw een their
activ ities for capital m anagem ent pu rposes, inclu ding regu latory
capital. Activ ities are split betw een the ‘bank ing book ’ and the
‘trading book ’ . Pu t sim ply , the bank ing book holds the m ore
traditional bank ing activ ities su ch as com m ercial bank ing, loans
and deposits. This w ou ld cov er lending to indiv idu als as w ell as
There is m ore to this than ju st this sim ple statem ent, and w e consider this
in Chapter 10.
Table 1.2 Bank analy sis ratios for capital strength
Ratio Calculation Notes
Core capital ratio Tier 1 capital/ A k ey ratio m onitored, in

Risk -w eighted assets particu lar, by rating
agencies as a m easu re of
high-qu ality non-repay able
capital, av ailable to absorb
losses incu rred by the bank
Tier 1 capital Eligible Tier 1 capital/ Another im portant ratio
ratio Risk -w eighted assets m onitored by inv estors and
rating agencies. Represents
the am ou nt of high-qu ality ,
non-repay able capital
av ailable to the bank
Total capital ratio Total capital/ Represents total capital
Risk -w eighted assets av ailable to the bank
Off-balance-sheet Off-balance-sheet and Measu re of adequ acy of
risk to total continent risk / capital against off-balance-
capital Total capital sheet risk inclu ding
deriv ativ es ex posu re and
com m itted, u ndraw n credit
lines
Source: Higson (1995).
corporates and other bank s, and so w ill interact w ith inv estm ent
bank ing bu s iness. 2 The trading book records w holesale m ark et
transactions , su ch as m ark et-m ak ing and proprietary trading in
bonds and deriv ativ es. Again, speak ing sim ply , the prim ary differ-
ence betw een the tw o book s is that the ov erriding principle of the
bank ing book is one of ‘bu y and hold’—that is, a long-term acqu isi-
tion. Assets m ay be held on the book for u p to 30 y ears or longer. The
trading book is ju st that, it em ploy s a trading philosophy so that
assets m ay be held for v ery short term s, less than one day in som e
cases. The regu latory capital and accou nting treatm ent of each book
differs. The prim ary difference here is that the trading book em ploy s
For a start, there w ill be a com m onality of clients. A corporate client w ill
borrow from a bank and m ay also retain the bank ’s u nderw riting or
stru ctu red fi nance departm ents to arrange a share issu e or secu ritization
on its behalf.
the ‘m ark -to-m ark et’ approach to record profi t and loss (P&L), w hich
is the daily ‘m ark ing’ of an asset to its m ark et v alu e. An increase or
decrease in the m ark on the prev iou s day ’s m ark is recorded as an
u nrealized profi t or loss on the book : on disposal of the asset, the
realized profi t or loss is the change in the m ark at disposal com pared
w ith its m ark at pu rchase.
The banking book

Traditional bank ing activ ity – su ch as deposits and loans – is
recorded in the bank ing book . The accou nting treatm ent for the
bank ing book follow s the accru al concept, w hich accru es interest
cashfl ow s as they occu r. There is no m ark to m ark et. The bank ing
book holds assets for w hich both corporate and retail cou nterparties
as w ell as bank ing cou nterparties are represented. So it is the ty pe of
bu s iness activ ity that dictates w hether it is placed in the bank ing
book , not the ty pe of cou nterparty or w hich departm ent of the bank
is condu cting it. Assets and liabilities on the bank ing book generate
interest rate and credit risk ex posu re for the bank . They also create
liqu idity and term m ism atch (‘gap’) risk s. Liqu idity refers to the ease
w ith w hich an asset can be transform ed into cash and to the ease
w ith w hich fu nds can be raised in the m ark et. So w e see that
‘liqu idity risk ’ actu ally refers to tw o related bu t separate issu es.
All these risk s form part of ALM. Interest rate risk m anagem ent is a
critical part of Treasu ry policy and ALM, w hile credit risk policy w ill
be set and dictated by the credit policy of the bank . Gap risk creates
an ex cess or shortgage of cash, w hich m u st be m anaged. This is the
cash m anagem ent part of ALM. There is also a m ism atch risk asso-
ciated w ith fi x ed rate and fl oating rate interest liabilities. The central
role of fi nancial m ark ets is to enable cash m anagem ent and interest
rate m anagem ent to be u ndertak en effi ciently . ALM of the bank ing
book w ill centre on interest rate risk m anagem ent and hedging as
w ell as liqu idity m anagem ent. Note how there is no ‘m ark et risk ’
for the bank ing book in principle, becau se there is no m ark ing to
m ark et. How ev er, the interest rate ex posu re of the book creates an
ex posu re that is su bject to m ark et m ov em ents in interest rates, so in
reality the bank ing book is ex posed to m ark et risk .
Trading book
Wholesale m ark et activ ity inclu ding m ark et-m ak ing and proprietary
trading is recorded in the trading book . Assets on the trading book
can be ex pected to hav e a high tu rnov er, althou gh not necessarily so,
and are m ark ed to m ark et daily . Cou nterparties to this trading
activ ity can inclu de other bank s and fi nancial institu tions su ch as
hedge fu nds, corporates and central bank s. Trading book activ ity
generates the sam e risk ex posu re as that on the bank ing book ,
inclu ding m ark et risk , credit risk and liqu idity risk . It also creates
a need for cash m anagem ent. Mu ch trading book activ ity inv olv es
deriv ativ e instru m ents , as opposed to ‘cash’ produ cts. Deriv ativ es
inclu de fu tu res, sw aps and options. These can be equ ity , interest
rate, credit, com m odity , foreign ex change (FX), w eather and other
deriv ativ es. Deriv ativ es are k now n as ‘off-balance-sheet’ instru -
m ents becau se they are recorded ‘off’ the (cash) balance sheet.
Their w idespread u se and acceptance has greatly im prov ed the effi -
ciency of the process behind risk ex posu re hedging for bank s and
other institu tions alik e.
Off-balance-sheet transactions refer to ‘contingent liabilities’, w hich
are so called becau se they refer to fu tu re ex posu re contracted now .
Thes e are not only deriv ativ es contracts su ch as interest rate sw aps
or w riting an option, bu t also inclu de gu arantees su ch as a credit line
to a third-party cu stom er or a grou p su bsidiary com pany . Thes e
represent a liability for the bank that m ay be requ ired to be honou red
at som e fu tu re date. In m ost cases they do not generate cash infl ow or
ou tfl ow at inception – u nlik e a cash transaction – bu t represent
fu tu re ex posu re. If a credit line is draw n on, it represents a cash
ou tfl ow and that transaction is then recorded on the balance sheet.
FINANCIAL STATEMENTS AND RATIOS

A k ey inform ation tool for bank analy sis is the fi nancial statem ent,
w hich com prises the balance sheet and the P&L accou nt. Assets on
the balance sheet shou ld equ al the assets on a bank ’s ALM report,
w hile receipt of rev enu e (su ch as interest and fees incom e) and
pay ou t of costs du ring a specifi ed period is recorded in the P&L
report or incom e statem ent.
The balance sheet

The balance sheet is a statem ent of a com pany ’ s assets and liabilities
as determ ined by accou nting ru les . It is a snapshot of a particu lar
point in tim e, and so by the tim e it is produ ced it is already ou t of
date. How ev er, it is an im portant inform ation statem ent. A nu m ber
of m anagem ent inform ation ratios are u sed w hen analy sing the
balance sheet; they are considered in the nex t chapter.
In Chapter 2 w e u se a hy pothetical ex am ple to illu strate balance
sheets. For a bank , there are u su ally fi v e parts to a balance sheet, split
u p in su ch a w ay to show separately
lending and deposits, or traditional bank bu sines s;
trading assets;
Treasu ry and interbank assets;
off-balance-sheet assets;
long-term assets, inclu ding fi x ed assets, shares in su bsidiary
com panies, together w ith equ ity and Tier 2 capital.
This is illu strated in Table 1.3. The actu al balance sheet of a retail or
com m ercial bank w ill differ signifi cantly from that of an inv estm ent
bank , du e to the relativ e im portance of their v ariou s bu sines s lines ,
bu t the basic lay ou t w ill be sim ilar.
Profit and loss report

The incom e statem ent for a bank is the P&L report, w hich records all
incom e and losses du ring a specifi ed period of tim e. A bank incom e
statem ent w ill show rev enu es that can be accou nted for as net
interest incom e, fees and com m issions, and trading incom e.
The precise m ix of these sou rces w ill refl ect the ty pe of bank ing
institu tion and the bu sines s lines it operates in. Rev enu e is offset by
operating (non-interest) ex penses, loan loss prov isions, trading losses
and tax ex pense.
A m ore ‘traditional’ com m ercial bank w ill hav e a m u ch higher
dependence on interest rev enu es than an inv estm ent bank that
Table 1.3 Com ponents of a bank balance sheet
Assets Liabilities
Cash Short-term liabilities

Loans Deposits
Financial instru m ents (long) Financial instru m ents (short)
Fix ed assets Long-dated debt
Off balance sheet (receiv ables) Equ ity
Off balance sheet (liabilities)
Table 1.4 Com ponents of bank incom e statem ent, ty pical

stru ctu re for retail bank
% Ex pressed as percentage of
Core operating incom e 100

Net interest incom e 64 Core operating incom e
Com m issions and fee incom e 31 Core operating incom e
Trading incom e 8 Core operating incom e
Net other operating incom e 8 Core operating incom e
Operating ex penses 61 Rev enu es
Personnel 38 Rev enu es
Other, depreciation
Loan loss prov isions 23 Pre-prov ision net incom e
Net operating incom e
Other non-operating incom e
Profi t before tax
Tax
Net incom e
Minority interest
Attribu table incom e
Source: Bank fi nancial statem ents.
engages in large-scale w holesale capital m ark et bu sines s. Inv est-

m ent bank s hav e a higher share of rev enu e com prising trading
and fee incom e. Table 1.4 show s the com ponents of a UK retail
bank ’s incom e statem ent.
The com position of earnings v aries w idely am ong different
institu tions . Figu re 1.2 show s the break dow n for a UK bu ilding
society and the UK branch of a US inv estm ent bank in 2005, as
reported in their fi nancial accou nts for that y ear.
Net interest income

The traditional sou rce of rev enu e for retail bank s – net interest
incom e (NII) – rem ains as su ch today (see Figu re 1.2). NII is
driv en by lending, interest-earning asset v olu m es and the net
y ield av ailable on these assets after tak ing into accou nt the cost
of fu nding. While the m ain focu s is on the loan book , the ALM
desk w ill also concentrate on the bank ’s inv estm ent portfolio.
The latter w ill inclu de cou pon receipts from m oney m ark et and
bond m ark et assets, as w ell as div idends receiv ed from any equ ity
holdings.
Figure 1.2 Com position of earnings.

Source: Bank fi nancial statem ents.
The cost of fu nding is a k ey v ariable in generating ov erall NII. For a

retail bank the cheapest sou rce of fu nds is deposits, especially non-
interest-bearing deposits su ch as chequ e accou nts. 3 Ev en in an era
of high-street com petition, the interest pay able on short-term
These are referred to as NIBLs (non-interest-bearing liabilities).

liabilities su ch as instant access deposits is far below the w holesale

m ark et interest rate. This is a fu nding adv antage for retail bank s
w hen com pared w ith inv estm ent bank s, w hich generally do not hav e
a retail deposit base. Other fu nding sou rces inclu de capital m ark ets
(senior debt), w holesale m ark ets (the interbank m oney m ark et),
secu ritized m ark ets and cov ered bonds . The ov erall com position
of fu nding signifi cantly affects net interest m argin and, if
constrained, can redu ce the activ ities of the bank .
The risk profi le of asset classes that generate y ields for the bank
shou ld lead to a range of net interest m argins being reported across
the sector, su ch that a bank w ith a strong u ns ecu red lending
franchise shou ld seek signifi cantly higher y ields than one inv esting
in secu red m ortgage loans; this refl ects the different risk profi les of
assets. The proportion of non-interest-bearing liabilities w ill also
hav e a signifi cant im pact on the net interest m argin of the institu -
tion. While a high net interest m argin is desirable, it shou ld also be
adequ ate retu rn for the risk incu rred in holding the assets.
Bank NII is sensitiv e to both credit risk and m ark et risk . Interest
incom e is sensitiv e to changes in interest rates and the m atu rity
profi le of the balance sheet. Bank s that hav e assets that m atu re
earlier than their fu nding liabilities w ill gain from an env ironm ent
of rising interest rates. The opposite applies w here the asset book has
a m atu rity profi le that is longer dated than the liability book . Note
that in a declining or low -interest-rate env ironm ent, bank s m ay
su ffer from negativ e net interest incom e irrespectiv e of their
asset–liability m atu rity profi le, as it becom es m ore and m ore diffi -
cu lt to pass on interest rate cu ts to depositors.
While inv estm ent bank s are less sensitiv e to changes in ov erall NII
ex pectations du e to their low er reliance on NII itself, their trading
book w ill also be sensitiv e to changes in interest rates.
Fee and commission income

Fee rev enu e is generated from the sale and prov ision of fi nancial
serv ices to cu stom ers. The lev el of fees and com m ission are
com m u nicated in adv ance to cu stom ers. Fee incom e k now n as
non-interest incom e is separate from trading incom e and is desirable
for bank s becau se it represents a stable sou rce of rev enu e that is not
ex posed to m ark et risk . It is also attractiv e becau se it prov ides an
opportu nity for the bank to cross-sell new produ cts and serv ices to
ex isting cu stom ers, and prov ision of these serv ices does not ex pose
the bank to additional credit or m ark et risk . Fee incom e represents

div ersifi cation in a bank ’s rev enu e base.
Note, thou gh, that althou gh fee-based bu sines s m ay not ex pose the
bank to m ark et risk directly , it does bring w ith it other risk s , and
these can inclu de indirect ex posu re to m ark et risk . 4 In addition, an
ability to prov ide fee-based fi nancial serv ices m ay requ ire signifi cant
inv estm ent in infrastru ctu re and hu m an resou rces.
Trading income
Trading incom e arises from the capital gain earned from bu y ing and
selling fi nancial instru m ents. These instru m ents inclu de both cash
and deriv ativ e (off-balanc e-sheet) instru m ents and can arise from
u ndertak ing m ark et-m ak ing, w hich in theory is u ndertak en to
m eet client dem ands and the proprietary bu sines s needs of the
bank ’s ow n trading book . Note that interest incom e earned w hile
holding assets on the trading book shou ld really be considered NII
and not trading incom e, bu t som etim es it is not stripped ou t from
ov erall trading book P&L. There is no u niform ity of approach am ong
bank s in this regard.
Trading incom e is the m ost v olatile form of bank rev enu e. Ev en a
record of consistent profi t in trading ov er a long period is no gu ar-
antee against fu tu re losses arising ou t of m ark et corrections or
sim ply m ak ing the w rong bet on fi nancial m ark ets. Trading activ ity
w as the fi rst ty pe of bank ing activ ity w hose risk ex posu re w as
m easu red u sing the Valu e-at-Risk m ethodology , w hich replaced
du ration-based risk m easu res in the 1990s.
Operating expenses
Bank ing operating costs ty pically contain hu m an resou rces costs
(rem u neration and other personnel-related ex penses) together w ith
other operating costs su ch as prem ises and infrastru ctu re costs,
depreciation charges and goodw ill. 5 Cost is generally m easu red as
For ex am ple, a strategy pu rsu ed by bank s in the 1990s w as to m erge w ith

or acqu ire insu rance com panies, creating so-called bancassurance grou ps.
Althou gh m u ch insu rance bu siness is fee-based, the acqu isition of insu r-
ance portfolios brou ght w ith it added m ark et risk for bank s.
These are accou nting term s com m on to all corporate entities and are not
u sed ju st to describe bank operating costs.
a proportion of rev enu e. A nu m ber of cost/incom e ratios are u sed by

analy sts, som e of w hich are giv en in Table 1.5.
The retu rn on equ ity (ROE) m easu re is probably the m ost com m only
encou ntered and is u su ally part of bank strategy , w ith a target ROE
lev el stated ex plicitly in m anagem ent objectiv es. Note that there is a
difference betw een accou nting ROE and m ark et ROE; the latter is
calcu lated as a price retu rn, rather lik e a standard P&L calcu lation,
tak en as the difference betw een m ark et prices betw een tw o dates.
Du ring the 1990s, and certainly into 2005, av erage requ ired ROE w as
in the order of 15% or higher – w ith inv estm ent bank s u su ally set a
higher target of 20% , 22% or ev en higher for certain higher risk
bu s iness. The ROE target needs to refl ect the relativ e risk s of
different bu s iness activ ities.
Retu rn on assets (ROA) is another com m on m easu re of perform ance.
It is calcu lated as follow s:
Cu rrent incom e (Interest incom e Fees) Asset v alu e
Both fi nancial statem ent P&L reports and m easu res su ch as ROE and
ROA are bland calcu lations of absolu te v alu es; that is, they do not
m ak e any adju stm ent for relativ e risk ex posu re so cannot stand too
m u ch com parison w ith equ iv alent fi gu res from another institu tion.
This is becau se risk ex posu re – not to m ention the specifi c ty pe of
bu s iness activ ity – w ill differ from one bank to another. How ev er,
there are general approx im ate v alu es that serv e as benchm ark s for
certain sectors, su ch as the 15% ROE lev el w e state abov e. Bank s
also calcu late risk -adju sted ratios.
Provisions
Bank s ex pect a percentage of loan assets, and other assets, to su ffer
loss or becom e u nrecov erable com pletely . Prov isions are set aside
ou t of reserv es to cov er for these losses each y ear; they are a charge
against the loan rev enu es of the bank . The size of the prov ision tak en
is a fu nction of w hat w riteoffs m ay be requ ired against the loan
portfolio in the cu rrent period and in the fu tu re, and the size and
adequ acy of loan loss reserv es cu rrently av ailable. In som e ju risdic-
tions there are regu latory requ irem ents that dictate the m inim u m
size of loss prov ision.
Prov isions fu nd the bank ’s loan loss reserv e, and the reserv e w ill
grow in size w hen the bank prov ides m ore for ex pected credit losses
than the actu al am ou nt that is w ritten off. If the bank believ es
Table 1.5 Bank cost/incom e ratios
Ratio Calculation Notes
Pre-tax ROE Pre-tax incom e/ Measu res the pre-tax retu rn on

Av erage shareholders equ ity . A m easu re abov e 20%
equ ity is v iew ed as abov e av erage and
strong
ROE Attribu table net incom e/ Measu res retu rn on equ ity .
Av erage shareholders’ A m easu re abov e 10% is
equ ity considered strong
ROA Net incom e/ Measu res retu rn on assets.
Av erage assets A m easu re abov e 1% is
considered strong
Cost–incom e Non-interest costs/ Non-interest costs m inu s non-
ratio Total net rev enu es cash item s su ch as goodw ill or
depreciation of intangible
assets. The cost to produ ce one
u nit of net interest and non-
interest incom e. The low er the
ratio, the m ore effi cient the
bank
Net interest Net interest incom e/ Difference betw een tax -
m argin Av erage earnings assets equ iv alent y ield on earning
assets and the rate paid on
fu nds to su pport those assets,
div ided by av erage earning
assets
Loan loss Loan loss prov ision/Pre- The proportion of pre-tax
prov ision prov ision, pre-tax incom e incom e that is being absorbed
by loan losses. This is the
credit cost of condu cting the
bu siness
Non-interest Non-interest incom e/ Non-interest incom e inclu des
incom e Net rev enu es serv ice charges on deposits,
tru st fees, adv isory fees,
serv icing fees, net trading
profi ts from trading book s, and
com m issions and fees from off-
balance-sheet item s. Generally ,
the higher the ratio, the greater
the bank ’s sensitiv ity to
changes in interest rates
su bsequ ently that the size of the reserv e bu ilt u p is in ex cess of w hat
is cu rrently requ ired, it m ay w rite back a percentage of it.
The am ou nt of prov isioning w ill v ary w ith the bu sines s cy cle.
Du ring a boom period in the cy cle, corporate and retail defau lt
rates are at historically low er lev els, and so a bank can afford to
low er the lev el of its prov isioning. How ev er, pru dent m anagem ent
dictates that senior m anagers are fam iliar w ith their m ark ets and are
able to ju dge w hen prov ision lev els shou ld increase. In other w ords,
bank s shou ld ‘k now their m ark et’.
REFERENCES
Hick s, J.R. (1939) Value and C apital, Ox ford: Clarendon Press.
Higson, C. (1995) Business Finance, Ox ford: Black w ell.
By Moorad Choudhry
Chapter
2
THE MONEY
MARKETS
P art of the global debt capital m ark ets, the m oney m ark ets are a
separate m ark et in their ow n right. Money m ark et secu rities are
defi ned as debt instru m ents w ith an original m atu rity of less than
1 y ear, althou gh it is com m on to fi nd that the m atu rity profi le of
bank s’ m oney m ark et desk s ru ns ou t to 2 y ears.
Money m ark ets ex ist in ev ery m ark et econom y , w hich is practically

ev ery cou ntry in the w orld. They are often the fi rst elem ent of a
dev eloping capital m ark et. In ev ery case they are com prised of
secu rities w ith m atu rities of u p to 12 m onths. Money m ark et
debt is an im portant part of global capital m ark ets, and facilitates
the sm ooth ru nning of the bank ing indu stry as w ell as prov iding
w ork ing capital for indu strial and com m ercial corporate institu -
tions. The m ark et prov ides u sers w ith a w ide range of opportu nities
and fu nding possibilities, and the m ark et is characterized by the
div erse range of produ cts that can be traded w ithin it. Money
m ark et instru m ents allow issu ers, inclu ding fi nancial organizations
and corporates, to raise fu nds for short-term periods at relativ ely low
interest rates. These issu ers inclu de sov ereign gov ernm ents, w ho
issu e Treasu ry bills, corporates issu ing com m ercial paper and bank s
issu ing bills and certifi cates of deposit. At the sam e tim e, inv estors
are attracted to the m ark et becau se the instru m ents are highly liqu id
and carry relativ ely low credit risk . The Treasu ry bill m ark et in any
cou ntry is that cou ntry ’s low est risk instru m ent, and consequ ently
carries the low est y ield of any debt instru m ent. Indeed, the fi rst
m ark et that dev elops in any cou ntry is u su ally the Treasu ry bill
m ark et. Inv estors in the m oney m ark et inclu de bank s, local
au thorities , corporations, m oney m ark et inv estm ent fu nds and
m u tu al fu nds, and indiv idu als.
In addition to cash instru m ents , the m oney m ark ets also consist of
a w ide range of ex change-traded and ov er-the-cou nter off-balance-
sheet deriv ativ e instru m ents. Thes e instru m ents are u sed m ainly to
establish fu tu re borrow ing and lending rates, and to hedge or change
ex isting interest rate ex posu re. This activ ity is carried ou t by both
bank s, central bank s and corporates. The m ain deriv ativ es are short-
term interest rate fu tu res, forw ard rate agreem ents and short-dated
interest rate sw aps, su ch as ov ernight index sw aps.
In this chapter w e rev iew the cash instru m ents traded in the m oney
m ark et. In fu rther chapters w e rev iew bank ing asset and liability
m anagem ent, and the m ark et in repu rchase agreem ents. Finally ,
w e consider the m ark et in m oney m ark et deriv ativ e instru m ents
inclu ding interest rate fu tu res and forw ard rate agreem ents.
THE MONEY MARKETS 25
INTRODUCTION
The cash instru m ents traded in m oney m ark ets inclu de the
follow ing:
tim e deposits;
Treasu ry bills;
certifi cates of deposit;
com m ercial paper;
bank er’s acceptances;
bills of ex change;
repo and stock lending.
Treasu ry bills are u sed by sov ereign gov ernm ents to raise short-term
fu nds, w hile certifi cates of deposit (CDs) are u sed by bank s to raise
fi nance. The other instru m ents are u sed by corporates and occasion-
ally bank s. Each instru m ent represents an obligation on the borrow er
to repay the am ou nt borrow ed on the m atu rity date together w ith
interest if this applies. The instru m ents abov e fall into one of tw o
m ain class es of m oney m ark et secu rities: those qu oted on a yield
basis and those qu oted on a discount basis . Thes e tw o term s are
discu s sed below . A repurchase agreement or ‘repo’ is also a m oney
m ark et instru m ent.
The calcu lation of interest in the m oney m ark ets often differs from
the calcu lation of accru ed interest in the corresponding bond m ark et.
Generally , the day -cou nt conv ention in the m oney m ark et is the
ex act nu m ber of day s that the instru m ent is held ov er the nu m ber of
day s in the y ear. In the UK sterling m ark et the y ear base is 365 day s,
so the interest calcu lation for sterling m oney m ark et instru m ents is
giv en by (2.1):
n
i 21
365
How ev er, the m ajority of cu rrencies, inclu ding the US dollar and the
eu ro, calcu late interest on a 360-day base. The process by w hich an
interest rate qu oted on one basis is conv erted to one qu oted on the
other basis is show n on p. 68. Those m ark ets that calcu late interest
based on a 365-day y ear are also listed on p. 68.
Dealers w ill w ant to k now the interest day base for a cu rrency before
dealing in it as foreign ex change (FX) or m oney m ark ets. Bloom berg
Figure 2.1 Bloom berg screen DCX u sed for US dollar m ark et,
3-m onth loan tak en ou t for v alu e 18 Nov em ber 2005.
2005 Bloom berg Finance L.P. All rights reserv ed. Used w ith perm ission.
u sers can u se screen DCX to look u p the nu m ber of day s of an

interest period. For instance, Figu re 2.1 show s screen DCX for the
US dollar m ark et, for a loan tak en ou t on 16 Nov em ber 2005 for
spot v alu e on 18 Nov em ber 2005 for a straight 3-m onth period.
This m atu res on 21 Febru ary 2006; w e see from Figu re 2.1 that
this is a good day . We see also that 20 Febru ary 2006 is a USD holiday .
The loan period is actu ally 95 day s, and 93 day s u nder the 30/360-day
conv ention (a bond m ark et accru ed interest conv ention). The
nu m ber of bu sines s day s is 62.
For the sam e loan tak en ou t in Singapore dollars, look at Figu re 2.2.
This show s that 20 Febru ary 2006 is not a pu blic holiday for SGD and
so the loan ru ns for the period 18 Decem ber 2005 to 20 Febru ary
2006.
Settlem ent of m oney m ark et instru m ents can be for v alu e today
(generally only w hen traded before m id-day ), tom orrow or 2 day s
forw ard, w hich is k now n as spot. The latter is m ost com m on.
Figure 2.2 Bloom berg screen DCX for Singapore dollar m ark et,
3-m onth loan tak en ou t for v alu e 18 Nov em ber 2005.
SECURITIES QUOTED ON
A YIELD BASIS
Tw o of the instru m ents in the list at the top of p. 25 are y ield-based
instru m ents .
Money m ark et deposits

Thes e are fi x ed interest term deposits of u p to 1 y ear w ith bank s and
secu rities hou s es. They are also k now n as time deposits or clean
deposits. They are not negotiable so cannot be liqu idated before
m atu rity . The interest rate on the deposit is fi x ed for the term
and related to the London Interbank Offered Rate (LIBOR) of the
sam e term . Interest and capital are paid on m atu rity .
LIBO R
The term LIBOR or ‘Libor’ com es from London Interbank Offered

Rate and is the interest rate at w hich one London bank offers fu nds
to another London bank of acceptable credit qu ality in the form of a
cash deposit. The rate is ‘fi x ed’ by the British Bank ers Association
at 11 a.m . ev ery bu s iness day m orning (in practice, the fi x is
u su ally abou t 20 m inu tes later) by tak ing the av erage of the
rates su pplied by m em ber bank s. The term LIBID is the bank ’s
‘bid’ rate – that is, the rate at w hich it pay s for fu nds in the London
m ark et. The qu ote spread for a selected m atu rity is therefore the
difference betw een LIBOR and LIBID. The conv ention in London is
to qu ote the tw o rates as LIBOR–LIBID, thu s m atching the y ield
conv ention for other instru m ents. In som e other m ark ets the
qu ote conv ention is rev ersed. EURIBOR is the interbank rate
offered for eu ros as reported by the Eu ropean Central Bank ,
fi x ed in Bru ssels. Figu re 2.3 show s the Bloom berg screen BBAM,
w hich is the daily listing of the BBA Libor fi x , as at 14 Septem ber
2009.
Figure 2.3 British Bank ers’ Ass ociation Libor fi x ing, Bloom berg
page BBAM, as at 14 Septem ber 2009.
2009 Bloom berg Finance L.P. All rights reserv ed. Used w ith perm iss ion.
The effectiv e rate on a m oney m ark et deposit is the annu al equ iv a-

lent interest rate for an instru m ent w ith a m atu rity of less than 1 y ear.
Example 2.1
A su m of £250,000 is deposited for 270 day s, at the end of w hich

the total proceeds are £261,000. What are the sim ple and effectiv e
rates of retu rn on a 365-day basis?
Total proceeds M
Sim ple rate of retu rn 1
Initial inv estm ent n
261,000 365
1 5 9481%
250,000 270
M n
Total proceeds
Effectiv e rate of retu rn 1
Initial inv estm ent
365 270
261,000
1 5 9938%
250,000
Certificates of deposit
Certifi cates of deposit (CDs) are receipts from bank s for deposits that
hav e been placed w ith them . They w ere fi rst introdu ced in the
sterling m ark et in 1958. The deposits them s elv es carry a fi x ed
rate of interest related to LIBOR and hav e a fi x ed term to m atu rity ,
so cannot be w ithdraw n before m atu rity . How ev er, the certifi cates
them s elv es can be traded in a secondary m ark et – that is, they are
negotiable. 1 CDs are therefore v ery sim ilar to negotiable m oney
m ark et deposits, althou gh the y ields are abou t 0.15% below the
equ iv alent deposit rates becau se of the added benefi t of liqu idity .
Most CDs issu ed are of betw een 1 and 3 m onths’ m atu rity , althou gh
they do trade in m atu rities of 1 to 5 y ears. Interest is paid on m atu rity
ex cept for CDs lasting longer than 1 y ear, w here interest is paid
annu ally or, occasionally , sem iannu ally .
Bank s, m erchant bank s and bu ilding societies issu e CDs to raise
fu nds to fi nance their bu s iness activ ities. A CD w ill hav e a stated
interest rate and fi x ed m atu rity date, and can be issu ed in any
denom ination. On issu e a CD is sold for face v alu e, so the settlem ent
proceeds of a CD on issu e are alw ay s equ al to its nom inal v alu e.
The interest is paid, together w ith the face am ou nt, on m atu rity .
The interest rate is som etim es called the coupon, bu t u nless the CD
A sm all nu m ber of CDs are non-negotiable.

is held to m atu rity this w ill not equ al the y ield, w hich is of cou rse
the cu rrent rate av ailable in the m ark et and v aries ov er tim e.
The largest grou p of CD inv estors are bank s, m oney m ark et
fu nds, corporates and local au thority treasu rers.
Unlik e cou pons on bonds, w hich are paid in rou nded am ou nts, CD
cou pon is calcu lated to the ex act day .
CD y ields
The cou pon qu oted on a CD is a fu nction of the credit qu ality of
the issu ing bank , its ex pected liqu idity lev el in the m ark et and, of
cou rse, the m atu rity of the CD, as this w ill be considered relativ e to
the m oney m ark et y ield cu rv e. As CDs are issu ed by bank s as part
of their short-term fu nding and liqu idity requ irem ent, issu e v olu m es
are driv en by the dem and for bank loans and the av ailability of
alternativ e sou rces of fu nds for bank cu stom ers. The credit qu ality
of the issu ing bank is the prim ary consideration, how ev er; in the
sterling m ark et the low est y ield is paid by ‘clearer’ CDs, w hich are
CDs issu ed by the clearing bank s – su ch as RBS NatWest plc, HSBC
and Barclay s plc. In the US m ark et ‘prim e’ CDs, issu ed by highly
rated dom estic bank s, trade at a low er y ield than non-prim e CDs.
In both m ark ets CDs issu ed by foreign bank s – su ch as French or
Japanese bank s – w ill trade at higher y ields.
Eu ro-CDs, w hich are CDs issu ed in a different cu rrency from that of
the hom e cu rrency , also trade at higher y ields in the US becau se of
reserv e and deposit insu rance restrictions.
If the cu rrent m ark et price of the CD inclu ding accru ed interest is P
and the cu rrent qu oted y ield is r, the y ield can be calcu lated giv en
the price, u sing (2.2):
M N im B
r 1 C 1 22
P B N sm
The price can be calcu lated giv en the y ield u sing (2.3):
N im N sm
P M 1 C 1 r
B B
N sm
F 1 r 23
B
w here C Qu oted cou pon on the CD;

M Face v alu e of the CD;
B Year day basis (365 or 360);
F Matu rity v alu e of the CD;
N im Nu m ber of day s betw een issu e and m atu rity ;
N sm Nu m ber of day s betw een settlem ent and m atu rity ;
N is Nu m ber of day s betw een issu e and settlem ent.
After issu e a CD can be traded in the secondary m ark et. The

secondary m ark et in CDs in the UK is v ery liqu id, and CDs w ill
trade at the rate prev alent at the tim e, w hich w ill inv ariably be
different from the cou pon rate on the CD at issu e. When a CD is
traded in the secondary m ark et, the settlem ent proceeds w ill need to
tak e into accou nt interest that has accru ed on the paper and the
different rate at w hich the CD has now been dealt. The form u la for
calcu lating the settlem ent fi gu re is giv en at (2.4) w hich applies to
the sterling m ark et and its 365 day -cou nt basis:
M Tenor C 100 36,500

Proceeds 24
Day s rem aining r 100 36,500
The settlem ent fi gu re for a new issu e CD is, of cou rse, its face
v alu e . . .! 2
The tenor of a CD is the life of the CD in day s, w hile days remaining

is the nu m ber of day s left to m atu rity from the tim e of trade.
The retu rn on holding a CD is giv en by (2.5):
Day s from pu rchase to m atu rity

1 Pu rchase y ield
R B 1
Day s from sale to m atu rity
1 Sale y ield
B
B
25
Day s held
With thank s to Del Boy du ring the tim e he w as at Tradition for pointing
this ou t after I’d ju st bou ght a sizeable chu nk of Japanese bank CDs circa
1993.
Example 2.2
A 3-m onth CD is issu ed on 6 Septem ber 1999 and m atu res on

6 Decem ber 1999 (m atu rity of 91 day s). It has a face v alu e of
£20,000,000 and a cou pon of 5.45% . What are the total m atu rity
proceeds?
91
Proceeds 20 m illions 1 0 0545
365
£20,271,753 42
What are the secondary m ark et proceeds on 11 October if the y ield
for short 60-day paper is 5.60% ?
20,271,753 42
P £20,099,066 64
56
1 0 056
365
On 18 Nov em ber the y ield on short 3-w eek paper is 5.215% .
What rate of retu rn is earned from holding the CD for the 38 day s
from 11 October to 18 Nov em ber?
56
1 0 0560 365
R 365 1 9 6355% .
38 38
1 0 052 15
365
An ex am ple of the w ay CDs and tim e deposits are qu oted on screen

is show n at Figu re 2.4, w hich show s one of the rates screens dis-
play ed by Tu llett & Tok y o, m oney brok ers in London, on a
Bloom berg screen. Essentially the sam e screen is display ed on
Reu ters. The screen has been reprodu ced w ith perm ission from
Tu llett’s and Bloom berg. The screen display s sterling interbank
and CD bid and offer rates for m atu rities u p to 1 y ear as at
18 Nov em ber 2005. The m atu rity m ark ed ‘O/N’ is the ov ernight
rate, w hich at that tim e w as 4.35–4.40. The m atu rity m ark ed ‘T/N’ is
‘tom -nex t’, or ‘tom orrow -to-the-nex t’, w hich is the ov ernight rate for
deposits com m encing tom orrow . Note that the liqu idity of CDs
m eans that they trade at a low er y ield to deposits. The bid–offer
conv ention in sterling is that the rate at w hich the m ark et-m ak er
w ill pay for fu nds – its borrow ing rate – is placed on the left.
A 6-m onth tim e deposit is lent at 4.62% .
Figure 2.4 Tu llett & Tok y o brok ers’ sterling m oney m ark ets
screen, 18 Nov em ber 2005.
Tu llett & Tok y o and Bloom berg Finance L.P. All rights reserv ed. Used w ith perm ission.
This is a rev ersal of the sterling m ark et conv ention of placing the
offered rate on the left-hand side, w hich ex isted u ntil the end of the
1990s.
U S dollar market rates
Treasury bills
The Treasu ry bill (T-bill) m ark et in the US is the m ost liqu id and
transparent debt m ark et in the w orld. Consequ ently , the bid–offer
spread on them is v ery narrow . The Treasu ry issu es bills at a
w eek ly au ction each Monday , m ade u p of 91-day and 182-day bills.
Ev ery fou rth w eek the Treasu ry also issu es 52-w eek bills as w ell.
As a resu lt there are large nu m bers of T-bills ou tstanding at any
one tim e. The interest earned on T-bills is not liable to state and
local incom e tax es. T-bill rates are the low est in the dollar m ark et
(as indeed any bill m ark et is in respectiv e dom estic env ironm ents)
and as su ch represent the corporate fi nancier’s risk-free interest
rate.
Federal funds
Com m ercial bank s in the US are requ ired to k eep reserv es on
deposit at the Federal Reserv e. Bank s w ith reserv es in ex cess of
requ ired reserv es can lend these fu nds to other bank s, and these
interbank loans are called federal funds or fed funds and are
u su ally ov ernight loans. Throu gh the fed fu nds m ark et, com m er-
cial bank s w ith ex cess fu nds are able to lend to bank s that are short
of reserv es, thu s facilitating liqu idity . The transactions are v ery
large denom inations, and are lent at the fed funds rate, w hich can
be a relativ ely v olatile interest rate becau se it fl u ctu ates w ith
m ark et shortages. On av erage, it trades abou t 15 basis points or so
below the ov ernight Libor fi x . The difference can be gau ged by
look ing at Figu res 2.5 and 2.6, w hich are the graphs for historical
USD fed fu nds and ov ernight Libor rates, respectiv ely .
Prime rate
The prime interest rate in the US is often said to represent the rate
at w hich com m ercial bank s lend to their m ost creditw orthy
cu stom ers. In practice, m any loans are m ade at rates below the
prim e rate, so the prim e rate is not the best rate at w hich highly
rated fi rm s m ay borrow . Nev ertheless, the prim e rate is a bench-
m ark indicator of the lev el of US m oney m ark et rates, and is
often u sed as a reference rate for fl oating-rate instru m ents . As the
m ark et for bank loans is highly com petitiv e, all com m ercial bank s
qu ote a single prim e rate, and the rate for all bank s changes
sim u ltaneou s ly .
SECURITIES QUOTED ON A
DISCOUNT BASIS
The rem aining m oney m ark et instru m ents are all qu oted on a
discount basis, and so are k now n as ‘discou nt’ instru m ents . This
m eans that they are issu ed on a discou nt to face v alu e, and are
redeem ed on m atu rity at face v alu e. Hence T-bills, bills of ex change,
bank er’s acceptances and com m ercial paper are ex am ples of m oney
m ark et secu rities that are qu oted on a discou nt basis – that is, they
are sold on the basis of a discou nt to par. The difference betw een the
price paid at the tim e of pu rchase and the redem ption v alu e (par) is
the interest earned by the holder of the paper. Ex plicit interest is not
paid on discou nt instru m ents , rather interest is refl ected im plicitly
in the difference betw een the discou nted issu e price and the par v alu e
receiv ed at m atu rity .
Figure 2.5 Bloom berg screen GP show ing fed fu nds rate for period
May –Nov em ber 2005.
Figure 2.6 Bloom berg screen GP show ing USD ov ernight Libor for
period May –Nov em ber 2005.
Treasury bills
Treasu ry bills (T-bills) are short-term gov ernm ent ‘IOUs’ of short
du ration, often 3-m onth m atu rity . For ex am ple, if a bill is issu ed on
10 Janu ary it w ill m atu re on 10 April. Bills of 1-m onth and 6-m onth
m atu rity are issu ed in certain m ark ets, bu t only rarely by the UK
Treasu ry . On m atu rity the holder of a T-bill receiv es the par v alu e
of the bill by presenting it to the central bank . In the UK m ost su ch
bills are denom inated in sterling bu t issu es are also m ade in eu ros.
In a capital m ark et, T-bill y ields are regarded as the risk-free y ield,
as they represent the y ield from short-term gov ernm ent debt. In
em erging m ark ets they are often the m ost liqu id instru m ents
av ailable for inv estors.
A sterling T-bill w ith £10 m illion face v alu e issu ed for 91 day s w ill
be redeem ed on m atu rity at £10 m illion. If the 3-m onth y ield at the
tim e of issu e is 5.25% , the price of the bill at issu e is:
10,000,000
P
91
1 0 0525
365
£9,870,800 69
In the UK m ark et the interest rate on discou nt instru m ents is qu oted
as a discount rate rather than a y ield. This is the am ou nt of discou nt
ex pressed as an annu alized percentage of the face v alu e, and not as a
percentage of the original am ou nt paid. By defi nition, the discou nt
rate is alw ay s low er than the corresponding y ield. If the discou nt rate
on a bill is d, then the am ou nt of discou nt is giv en by (2.6):
n
dvalue M d 26
B
The price P paid for the bill is the face v alu e m inu s the discou nt
am ou nt, giv en by (2.7):
1 d N sm 365
P 100 27
100
If w e k now the y ield on the bill then w e can calcu late its price at
issu e by u sing the sim ple present v alu e form u la, as show n at (2.8):
M
P 28
N sm
1 r
365
The discou nt rate d for T-bills is calcu lated u sing (2.9):

B
d 1 P 29
n
The relationship betw een discou nt rate and tru e y ield is giv en by
(2.10):
r
d n
1 r
B
2 10
d
r n
1 d
B
Example 2.3
A 91-day £100 T-bill is issu ed w ith a y ield of 4.75% . What is its

issu e price?
91
P £100 1 0 0475
365
£98 80
A UK T-bill w ith a rem aining m atu rity of 39 day s is qu oted at a
discou nt of 4.95% What is the equ iv alent y ield?
0 0495
r
39
1 0 0495
365
4 976%
If a T-Bill is traded in the secondary m ark et, the settlem ent proceeds
from the trade are calcu lated u sing (2.11):
M Day s rem aining d
Proceeds M 2 11
B 100
Bank er’s acceptances

A bank er’s acceptance is a w ritten prom ise issu ed by a borrow er to
a bank to repay borrow ed fu nds. The lending bank lends fu nds and in
retu rn accepts the bank er’s acceptance. The acceptance is negotiable
and can be sold in the secondary m ark et. The inv estor w ho bu y s the
acceptance can collect the loan on the day that repay m ent is du e.
If the borrow er defau lts, the inv estor has legal recou rse to the bank
that m ade the fi rst acceptance. Bank er’s acceptances are also k now n
as bills of exchange, bank bills, trade bills or commercial bills.
Essentially , bank er’s acceptances are instru m ents created to
facilitate com m ercial trade transactions . The instru m ent is called
a banker’s acceptance becau se a bank accepts the u ltim ate
responsibility to repay the loan to its holder. The u se of bank er’s
acceptances to fi nance com m ercial transactions is k now n as accep-
tance financing. The transactions for w hich acceptances are created
inclu de im port and ex port of goods, the storage and shipping of goods
betw een tw o ov erseas cou ntries, w here neither the im porter nor the
ex porter is based in the hom e cou ntry , 3 and the storage and shipping
of goods betw een tw o entities based at hom e. Acceptances are dis-
cou nt instru m ents and are pu rchased by bank s, local au thorities and
m oney m ark et inv estm ent fu nds.
The rate that a bank charges a cu stom er for issu ing a bank er’s
acceptance is a fu nction of the rate at w hich the bank think s it
w ill be able to sell it in the secondary m ark et. A com m ission is
added to this rate. For ineligible bank er’s acceptances (see below )
the issu ing bank w ill add an am ou nt to offset the cost of additional
reserv e requ irem ents .
Eligible bank er’s acceptance

An accepting bank that chooses to retain a bank er’s acceptance in
its portfolio m ay be able to u se it as collateral for a loan obtained
from the central bank du ring open m ark et operations – for ex am ple,
the Bank of England in the UK and the Federal Reserv e in the US.
Not all acceptances are eligible to be u sed as collateral in this w ay , as
they m u st m eet certain criteria set by the central bank . The m ain
requ irem ent for eligibility is that the acceptance m u st be w ithin a
certain m atu rity band (a m ax im u m of 6 m onths in the US and
3 m onths in the UK), and that it m u st hav e been created to fi nance
a self-liqu idating com m ercial transaction. In the US eligibility is also
im portant becau se the Federal Reserv e im pos es a reserv e requ ire-
m ent on fu nds raised v ia bank er’s acceptances that are ineligible.
A bank er’s acceptance created to fi nance su ch a transaction is k now n as a

third-party acceptance.
Bank er’s acceptances sold by an accepting bank are potential liabil-

ities for the bank , bu t the reserv e im pos es a lim it on the am ou nt of
eligible bank er’s acceptances that a bank m ay issu e. Bills eligible for
deposit at a central bank enjoy a fi ner rate than ineligible bills, and
also act as a benchm ark for prices in the secondary m ark et.
COMMERCIAL PAPER
Com m ercial paper (CP) is a short-term m oney m ark et fu nding
instru m ent issu ed by corporates. In the UK and US it is a discou nt
instru m ent. A com pany ’s short-term capital and working capital
requ irem ent is u s u ally sou rced directly from bank s, in the form of
bank loans. An alternativ e short-term fu nding instru m ent is CP,
w hich is av ailable to corporates that hav e a su ffi ciently strong
credit rating. CP is a short-term u nsecu red prom issory note. The
issu er of the note prom ises to pay its holder a specifi ed am ou nt on a
specifi ed m atu rity date. CP norm ally has a zero cou pon and trades at
a discount to its face v alu e. The discou nt represents interest to the
inv estor in the period to m atu rity . CP is ty pically issu ed in bearer
form , althou gh som e issu es are in registered form .
Originally , the CP m ark et w as restricted to borrow ers w ith high
credit ratings, and althou gh low er rated borrow ers do now issu e
CP, som etim es by obtaining credit enhancem ents or setting u p
collateral arrangem ents , issu ance in the m ark et is still dom inated
by highly rated com panies. The m ajority of issu es are v ery short
term , from 30 to 90 day s in m atu rity ; it is ex trem ely rare to
observ e paper w ith a m atu rity of m ore than 270 day s or 9 m onths.
This is becau se of regu latory requ irem ents in the US,4 w hich state
that debt instru m ents w ith a m atu rity of less than 270 day s need not
be registered. Com panies therefore issu e CP w ith a m atu rity low er
than 9 m onths and so av oid the adm inistration costs associated w ith
regis tering issu es w ith the SEC.
There are tw o m ajor m ark ets, the US dollar m ark et w ith an
ou tstanding am ou nt in 2005 ju st u nder $1 trillion, and the Eu ro-
com m ercial paper m ark et w ith an ou tstanding v alu e of $490 billion
at the end of 2005. 5 Com m ercial paper m ark ets are w holesale
This is the Secu rities Act of 1933. Registration is w ith the Secu rities and
Ex change Com m ission.
Source: BIS.
Table 2.1 Com parison of US CP and Eu rocom m ercial CP.
US CP Eurocom m ercial
CP
Cu rrency US dollar Any eu ro cu rrency

Matu rity 1–270 day s 2–365 day s
Com m on m atu rity 30–180 day s 30–90 day s
Interest Zero cou pon, issu ed at discou nt Fix ed cou pon
Qu otation On a discou nt rate basis On a y ield basis
Settlem ent
Registration Bearer form Bearer form
Negotiable Yes Yes
m ark ets, and transactions are ty pically v ery large. In the US ov er a

third of all CP is pu rchased by m oney m ark et u nit tru sts, k now n as
m u tu al fu nds; other inv estors inclu de pension fu nd m anagers, retail
or com m ercial bank s, local au thorities and corporate treasu rers. A
com parison betw een USCP and ECP is giv en in Table 2.1.
Althou gh there is a secondary m ark et in CP, v ery little trading
activ ity tak es place since inv estors generally hold CP u ntil m atu rity .
This is to be ex pected becau se inv estors pu rchase CP that m atches
their specifi c m atu rity requ irem ent. When an inv estor does w ish to
sell paper, it can be sold back to the dealer or, w here the issu er has
placed the paper directly in the m ark et (and not v ia an inv estm ent
bank ), it can be sold back to the issu er.
Com m ercial paper program m es

The issu ers of CP are often div ided into tw o categories of com pany :
bank ing and fi nancial institu tions and non-fi nancial com panies.
The m ajority of CP issu es are by fi nancial com panies. Financial
com panies inclu de not only bank s bu t also the fi nancing arm s of
corporates – su ch as British Airw ay s, BP and Ford Motor Credit. Most
of the issu ers hav e strong credit ratings, bu t low er rated borrow ers
hav e tapped the m ark et, often after arranging credit su pport from a
higher rated com pany , su ch as a letter of credit from a bank , or by
arranging collateral for the issu e in the form of high-qu ality assets
su ch as Treasu ry bonds . CP issu ed w ith credit su pport is k now n as
credit-supported commercial paper, w hile paper back ed w ith assets
is k now n natu rally enou gh as asset-backed commercial paper. Paper
that is back ed by a bank letter of credit is term ed LO C paper.
Althou gh bank s charge a fee for issu ing letters of credit, borrow ers
are often happy to arrange for this, since by so doing they are able to
tap the CP m ark et. The y ield paid on an issu e of CP w ill be low er
than that on a com m ercial bank loan.
Althou gh CP is a short-dated secu rity , ty pically of 3-to-6-m onth

m atu rity , it is issu ed w ithin a longer term program m e, u su ally for
3 to 5 y ears for eu ro paper; US CP program m es are often open-ended.
For ex am ple, a com pany m ight arrange a 5-y ear CP program m e w ith
a lim it of $100 m illion. Once the program m e is established the
com pany can issu e CP u p to this am ou nt – say , for m atu rities of
30 or 60 day s. The program m e is continu ou s and new CP can be
issu ed at any tim e, daily if requ ired. The total am ou nt in issu e
cannot ex ceed the lim it set for the program m e. A CP program m e
can be u s ed by a com pany to m anage its short-term liqu idity – that is,
its w ork ing capital requ irem ents . New paper can be issu ed w henev er
a need for cash arises, and for an appropriate m atu rity .
Issu ers often roll ov er their fu nding and u se fu nds from a new issu e
of CP to redeem a m atu ring issu e. There is a risk that an issu er
m ight be u nable to roll ov er the paper w here there is a lack of inv estor
interest in the new issu e. To prov ide protection against this risk
issu ers often arrange a standby line of credit from a bank , norm ally
for all of the CP program m e, to draw against in the ev ent that it
cannot place a new issu e.
There are tw o m ethods by w hich CP is issu ed, k now n as direct-

issued or direct paper and dealer-issued or dealer paper. Direct
paper is sold by the issu ing fi rm directly to inv estors, and no
agent bank or secu rities hou s e is inv olv ed. It is com m on for fi nancial
com panies to issu e CP directly to their cu stom ers, often becau se
they hav e continu ou s program m es and constantly roll ov er their
paper. It is therefore cost-effectiv e for them to hav e their ow n
sales arm and sell their CP direct. The treasu ry arm s of certain
non-fi nancial com panies also issu e direct paper; this inclu des, for
ex am ple, British Airw ay s plc corporate treasu ry , w hich ru ns a con-
tinu ou s direct CP program m e, u sed to prov ide short-term w ork ing
capital for the com pany . Dealer paper is paper that is sold u sing a
bank ing or secu rities hou s e interm ediary . In the US, dealer CP is
effectiv ely dom inated by inv estm ent bank s, as retail (com m ercial)
bank s w ere u ntil recently forbidden from u nderw riting com m ercial
paper. This restriction has since been rem ov ed and now both
inv estm ent bank s and com m ercial paper u nderw rite dealer paper.
Com m ercial paper y ields

CP is sold at a discou nt to its m atu rity v alu e, and the difference
betw een this m atu rity v alu e and the pu rchase price is the interest
earned by the inv estor. The CP day -cou nt base is 360 day s in the US
and eu ro m ark ets, and 365 day s in the UK. The paper is qu oted on a
discou nt y ield basis , in the sam e m anner as T-bills. The y ield on CP
follow s that of other m oney m ark et instru m ents and is a fu nction of
the short-dated y ield cu rv e. The y ield on CP is higher than the T-bill
rate; this is du e to the credit risk that the inv estor is ex posed to w hen
holding CP, for tax reasons (in certain ju risdictions interest earned
on T-bills is ex em pt from incom e tax ) and becau se of the low er lev el
of liqu idity av ailable in the CP m ark et. CP also pay s a higher y ield
than CDs, du e to the low er liqu idity of the CP m ark et.
Althou gh CP is a discou nt instru m ent and trades as su ch in the US
and UK, eu ro cu rrency eu rocom m ercial paper trades on a y ield
basis, sim ilar to a CD. The ex pressions below illu strate the
relationship betw een tru e y ield and discou nt rate:
M
P 2 12
Day s
1 r
Year
r
rd 2 13
Day s
1 r
Year
rd
r 2 14
Day s
1 rd
Year
w here M is the face v alu e of the instru m ent, rd is the discou nt rate
and r the tru e y ield.
Example 2.4
1. A 60-day CP note has a nom inal v alu e of £100,000. It is issu ed

at a discou nt of 7 % per annu m . The discou nt is calcu lated as:
£100,000 0 075 60
D is
365
£1,232 88
The issu e price for the CP is therefore £100,000 – £1,232, or
£98,768. The m oney m ark et y ield on this note at the tim e of

issu e is:
365 0 075
100% 7 594%
365 0 075 60
Another w ay to calcu late this y ield is to m easu re the capital
gain (the discou nt) as a percentage of the CP’s cost, and conv ert
this from a 60-day y ield to a 1-y ear (365-day ) y ield, as show n
below :
1,232 365
r 100%
98,768 60
7 588%
2. ABC plc w ishes to issu e CP w ith 90 day s to m atu rity . The
inv estm ent bank m anaging the issu e adv ises that the discou nt
rate shou ld be 9.5% . What shou ld the issu e price be, and
w hat is the m oney m ark et y ield for inv estors?
100 0 095 90
D is
365
2 342
The issu e price w ill be 97.658.
The y ield to inv estors w ill be:
2 342 365
100% 9 725%
97 658 90
Asset-back ed com m ercial paper

The rise in secu ritization has led to the grow th of short-term
instru m ents back ed by cashfl ow s from other assets, k now n as
asset-backed commercial paper (ABCP). Secu ritization is the prac-
tice of u sing cash fl ow s from a specifi ed asset, su ch as residential
m ortgages, car loans or com m ercial bank loans, as back ing for an
issu e of bonds. The assets them s elv es are transferred from the
original ow ner (the originator) to a specially created legal entity
k now n as a special purpose vehicle (SPV), so as to m ak e them sep-
arate and bank ru ptcy -rem ote from the originator. In the m eantim e,
the originator is able to benefi t from capital m ark et fi nancing, often
charged at a low er rate of interest than that earned by the originator
on its assets. Secu ritized produ cts are not m oney m ark et instru -
m ents, and althou gh ABCP is, m ost tex tbook s treat ABCP as part
of the stru ctu red produ cts m ark et rather than as a m oney m ark et
produ ct.
Generally , secu ritization is u sed as a fu nding instru m ent by
com panies for three m ain reasons : it offers low er cost fu nding
com pared w ith a traditional bank loan or bond fi nancing; it is a
m echanism by w hich assets su ch as corporate loans or m ortgages
can be rem ov ed from the balance sheet, thu s im prov ing the lender’s
retu rn on assets or retu rn on equ ity ratios; and it increases a
borrow er’s fu nding options. When entering into secu ritization, an
entity m ay issu e term secu rities against assets into the pu blic or
priv ate m ark et, or it m ay issu e com m ercial paper v ia a special
v ehicle k now n as a conduit. These condu its are u su ally sponsored
by com m ercial bank s.
Entities u su ally access the com m ercial paper m ark et in order to
secu re perm anent fi nancing, rolling ov er indiv idu al issu es as part
of a longer term programme and u sing interest rate sw aps to arrange a
fi x ed rate if requ ired. Conv entional CP issu es are ty pically su pported
by a line of credit from a com m ercial bank , and so this form of
fi nancing is in effect a form of bank fu nding. Issu ing ABCP
enables an originator to benefi t from m oney m ark et fi nancing
that it m ight otherw ise not hav e access to becau se its credit
rating is not su ffi ciently strong. A bank m ay also issu e ABCP for
balance sheet or fu nding reasons . ABCP trades, how ev er, ex actly as
conv entional CP. The adm inistration and legal treatm ent is m ore
onerou s, how ev er, becau se of the need to establish the CP tru st
stru ctu re and issu ing SPV. The serv icing of an ABCP program m e
follow s that of conv entional CP and is carried ou t by the sam e
entities, su ch as the ‘Tru st’ arm s of bank s su ch as Deu tsche Bank
and Bank of New York Mellon.
Ex am ple 2.5 (see p. 46) details a hy pothetical ABCP issu e and ty pical
stru ctu re.
Basic characteristics
Ass et-back ed CP program m es are inv ariably issu ed ou t of specially
incorporated legal entities (the SPV, som etim es called the SPC for
special pu rpose corporation), w hich in the m oney m ark ets are
k now n as condu its. They are ty pically established by com m erical
bank s and fi nance com panies to enable them to access Libor-based
fu nding, at close to Libor, and to obtain regu latory capital relief.

This can be done for the bank or a cu stom er.
An ABCP condu it has the follow ing featu res:
it is a bank ru ptcy -rem ote legal entity that issu es com m ercial
paper to fi nance a pu rchase of assets from a seller of assets;
the interest on the CP issu ed by the condu it, and its principal on
m atu rity , w ill be paid ou t of the receipts on the assets pu rchased
by the condu it;
condu its hav e also been set u p to ex ploit credit arbitrage
opportu nities, su ch as raising fi nance at Libor to inv est in
high-qu ality assets su ch as inv estm ent-grade-rated stru ctu red
fi nance secu rities that pay abov e Libor.
The assets that can be fu nded v ia a condu it program m e are m any and
v aried; to date they hav e inclu ded:
trade receiv ables and equ ipm ent lease receiv ables;
credit card receiv ables;
au to loans and leases;
corporate loans; franchise loans, m ortgage loans;
real estate leases;
fu tu re (ex pected) cashfl ow s.
Condu its are class ifi ed into a ‘program m e ty pe’, w hich refers to the
m ak eu p of the u nderly ing asset portfolio. This can be single-s eller or
m u lti-seller, w hich indicates how m any institu tions or entities are
selling assets to the condu it. They are also designated as fu nding or
secu rities credit arbitrage v ehicles.
A special class of condu it k now n as a stru ctu red inv estm ent v ehicle
(SIV, som etim es called a special inv estm ent v ehicle) w as introdu ced
that issu ed both CP and m ediu m -term notes (MTNs), u s ed to fu nd
the pu rchase of longer dated assets su ch as ABS and CDO secu rities.
Thes e w ere described as ‘credit arbitrage v ehicles’ bu t w ere as m u ch
fu nding arbitrage v ehicles. They w ere the fi rst casu alties of the
2007–2008 fi nancial crisis and w ere either w ou nd u p or consolidated
by their parent bank s. The v ehicles are now ex tinct and as a concept
the SIV has been debu nk ed.
Figu re 2.7 illu strates a ty pical ABCP stru ctu re issu ing to the USCP
and ECP m ark ets.
Figure 2.7 Single-seller condu it.
Example 2.5 Illu stration of ABCP stru ctu re
In Figu re 2.8 w e illu strate a hy pothetical ex am ple of secu ritization

of bank loans in an ABCP stru ctu re. The loans hav e been m ade by
ABC Bank plc and are secu red on borrow ers’ specifi ed assets. They
are denom inated in sterling. These m ight be a lien on property ,
cashfl ow s of the borrow ers’ bu sines s or other assets. The bank
m ak es a ‘tru e sale’ of the loans to a special pu rpose v ehicle, nam ed
Clarem ont Finance. This has the effect of rem ov ing the loans from
its balance sheet and also protecting them in the ev ent of bank -
ru ptcy or liqu idation of ABC Bank . The SPV raises fi nance by
issu ing com m ercial paper, v ia its appointed CP dealer(s), w hich is
the Treasu ry desk of MC Inv estm ent Bank . The paper is rated
A-1/P-1 by the rating agencies and is issu ed in US dollars. The
liability of the CP is m et by the cashfl ow from the original ABC
Bank loans.
ABC Manager is the SPV m anager for Clarem ont Finance, a
su bsidiary of ABC Bank . Liqu idity for Clarem ont Finance is
prov ided by ABC Bank , w ho also act as the hedge prov ider. The
hedge is effected by m eans of a sw ap agreem ent betw een
Clarem ont and ABC Bank ; in fact, ABC w ill fi x a cu rrency
sw ap w ith a sw ap bank cou nterparty , w ho is m ost lik ely to be
the sw ap desk of MC Inv estm ent Bank . The tru stee for the
transaction is Tru st Bank Lim ited, w ho act as secu rity tru stee and
represent the inv estors in the ev ent of defau lt.
The other term s of the stru ctu re are as follow s:

Program m e US$500 m illion
facility lim it
Facility term The facility is av ailable on an u ncom m itted
basis renew able annu ally by the agreem ent of
the SPV m anager and the secu rity tru stee.
It has a fi nal term ination date fi v e y ears from
fi rst issu e.
Tenor of paper Sev en day s to 270 day s.
Pre-pay m ent In the ev ent of pre-pay m ent of a loan, the
gu arantee seller w ill prov ide Clarem ont Finance w ith a
gu aranteed rate of interest for the relev ant
interest period.
Hedge agreem ent Clarem ont Finance w ill enter into cu rrency
and interest rate sw aps w ith the hedge pro-
v ider to hedge any interest rate or cu rrency
risk that arises.
Ev ents of defau lt In the ev ent of defau lt the issu ance pro-
gram m e w ill cease and in certain ev ents
w ill lead Clarem ont Finance to pay loan
collections into a segregated specifi c collec-
tion accou nt. Ev ents of defau lt can inclu de
non-pay m ent by Clarem ont Finance u nder
the transaction docu m entation, insolv ency
or rank ing of charge (w here the charge ceases
to be a fi rst-rank ing charge ov er the assets of
Clarem ont Finance).
Loans gu arantee: Loans pu rchased by Clarem ont Finance w ill
m eet a range of eligibility criteria, specifi ed
in the transaction-offering circu lar. Thes e
criteria w ill inclu de requ irem ents on cu r-
rency of the loans, their term to m atu rity ,
confi rm ation that they can be assigned, that
they are not in arrears, and so on.
Borrowers
Principal interest Loans
ABC Bank
( seller)
‘True sale’ of loans
ABC Bank Claremont

Finance ABC Manager
( liquidity)
( issuing SPV)
ABC Bank
( hedge provider) CP $
Trust Bank
MC Investment
Bank
( CP dealer)
CP $
CP investors
Figure 2.8 ‘Clarem ont Finance’ ABCP stru ctu re.
REPO
The term repo is u sed to cov er one of tw o different transactions ,
the classic repo and the sell/buyback, and som etim es is spok en of
in the sam e contex t as a sim ilar instru m ent, the stock loan. A
fou rth instru m ent is also econom ically sim ilar in som e respects
to a repo, k now n as the total return swap, w hich is now com m only
encou ntered as part of the m ark et in credit deriv ativ es. How ev er,
althou gh these transactions differ in term s of their m echanics, legal
docu m entation and accou nting treatm ent, the econom ic effect of
each of them is v ery sim ilar. The stru ctu re of any particu lar m ark et
and the m otiv ations of particu lar cou nterparties w ill determ ine
w hich transaction is entered into; there is also som e crossov er
betw een m ark ets and participants .
Mark et participants enter into classic repo becau se they w ish to

inv est cash, for w hich the transaction is deem ed to be cash-
driven, or becau se they w ish to borrow a certain stock , for
w hich pu rpose the trade is stock-driven. A sell/bu y back , w hich is
som etim es referred to as a buy–sell, is entered into for sim ilar
reasons bu t the trade itself operates u nder different m echanics
and docu m entation. 6 A stock loan is ju st that, a borrow ing of
stock against a fee. Long-term holders of stock w ill therefore
enter into stock loans sim ply to enhance their portfolio retu rns.
We w ill look at the m otiv ations behind the total retu rn sw ap in a
later chapter.
Note that du ring the interbank liqu idity crisis from Septem ber
2008 to w ell into 2009, w hen u nsecu red inter-bank m ark ets dried
u p, repo w as the only fu nding m echanism still av ailable to m any
bank s.
Definition
A repo agreem ent is a transaction in w hich one party sells secu rities
to another, and at the sam e tim e and as part of the sam e transaction
com m its to repu rchas e identical secu rities on a specifi ed date at a
specifi ed price. The seller deliv ers secu rities and receiv es cash from
the bu y er. The cash is su pplied at a predeterm ined rate – the repo
rate – that rem ains constant du ring the term of the trade. On
m atu rity the original seller receiv es back collateral of equ iv alent
ty pe and qu ality , and retu rns the cash plu s repo interest. One
party to the repo requ ires either the cash or the secu rities and
prov ides collateral to the other party , as w ell as som e form of
com pensation for the tem porary u se of the desired asset. Althou gh
legal title to the secu rities is transferred, the seller retains both the
econom ic benefi ts and the m ark et risk of ow ning them . This m eans
that the ‘seller’ w ill su ffer if the m ark et v alu e of the collateral drops
du ring the term of the repo, as she still retains benefi cial ow ners hip
of the collateral. The ‘bu y er’ in a repo is not affected in P&L
accou nt term s if the v alu e of the collateral drops, althou gh there
are other concerns for the bu y er if this happens.
We shall u se the term ‘sell/bu y back ’ throu ghou t this book . A repo is still a
repo w hether it is cash-driv en or stock -driv en, and one person’s stock -
driv en trade m ay w ell be another’s cash-driv en one.
We hav e giv en here the legal defi nition of repo. How ev er, the pu rpose
of the transaction as w e hav e described abov e is to borrow or lend
cash, w hich is w hy w e hav e u sed inv erted com m as w hen referring to
sellers and bu y ers. The ‘seller’ of stock is really interested in borrow -
ing cash, on w hich (s)he w ill pay interest at a specifi ed interest rate.
The ‘bu y er’ requ ires secu rity or collateral against the loan he has
adv anced, and/or the specifi c secu rity to borrow for a period of tim e.
The fi rst and m ost im portant thing to state is that repo is a secu red
loan of cash, and w ou ld be categorized as a m oney m ark et y ield
instru m ent. 7
The classic repo

The classic repo is the instru m ent encou ntered in the US, UK and
other m ark ets. In a class ic repo one party w ill enter into a contract
to sell secu rities, sim u ltaneou s ly agreeing to pu rchase them back
at a specifi ed fu tu re date and price. The secu rities can be bonds or
equ ities bu t can also be m oney m ark et instru m ents, su ch as T-bills.
The bu y er of the secu rities is handing ov er cash, w hich on the
term ination of the trade w ill be retu rned to him , and on w hich he
w ill receiv e interest.
The seller in a class ic repo is selling or offering stock , and therefore
receiv ing cash, w hereas the bu y er is bu y ing or bidding for stock , and
consequ ently pay ing cash. So, if the 1-w eek repo interest rate is
qu oted by a m ark et-m ak ing bank as ‘5 12 –5 14 ’, this m eans that the
m ark et-m ak er w ill bid for stock – that is, lend the cash – at
5.50% and offers stock or pay s interest on cash at 5.25% .
Illustration of classic repo

There w ill be tw o parties to a repo trade, let u s say Bank A (the seller
of secu rities) and Bank B (the bu y er of secu rities). On the trade date
the tw o bank s enter into an agreem ent w hereby on a set date – the
value or settlement date – Bank A w ill sell to Bank B a nom inal
That is, a m oney m ark et instru m ent qu oted on a y ield instru m ent, sim ilar
to a bank deposit or a CD. The other class of m oney m ark et produ cts are
discount instru m ents su ch as T-bills or CP.
am ou nt of secu rities in ex change for cash. 8 The price receiv ed for the
secu rities is the m ark et v alu e of the stock on the v alu e date. The
agreem ent also dem ands that on the term ination date Bank B w ill
sell identical stock back to Bank A at the prev iou sly agreed price,
and, consequ ently , Bank B w ill hav e its cash retu rned w ith interest at
the agreed repo rate.
In essence, a repo agreem ent is a secu red loan (or collateralized loan)
in w hich the repo rate refl ects the interest charged.
On the v alu e date, stock and cash change hands. This is k now n as the
start date, first leg or opening leg, w hile the term ination date is
k now n as the second leg or closing leg. When the cash is retu rned
to Bank B, it is accom panied by the interest charged on the cash
du ring the term of the trade. This interest is calcu lated at a specifi ed
rate k now n as the repo rate. It is im portant to rem em ber that,
althou gh in legal term s the stock is initially ‘sold’ to Bank B, the
econom ic effects of ow ners hip are retained w ith Bank A. This m eans
that if the stock falls in price it is Bank A that w ill su ffer a capital
loss. Sim ilarly , if the stock inv olv ed is a bond and there is a cou pon
pay m ent du ring the term of trade, this cou pon is to the benefi t of
Bank A and, althou gh Bank B w ill hav e receiv ed it on the cou pon
date, it m u st be handed ov er on the sam e day or im m ediately after to
Bank A. This refl ects the fact that, althou gh legal title to the col-
lateral passes to the repo bu y er, the econom ic costs and benefi ts of
the collateral rem ain w ith the seller.
A class ic repo transaction is su bject to a legal contract signed in

adv ance by both parties. A standard docu m ent w ill su ffi ce; it is not
necessary to sign a legal agreem ent prior to each transaction.
Note that, althou gh w e hav e called the tw o parties in this case

‘Bank A’ and ‘Bank B’, it is not only bank s that get inv olv ed in
repo transactions – w e hav e u sed these term s for the pu rposes of
illu stration only .
The basic m echanism is illu strated in Figu re 2.9.
The tw o term s are not necessarily sy nony m ou s. The v alu e date in a trade
is the date on w hich the transaction acqu ires v alu e – for ex am ple, the date
from w hich accru ed interest is calcu lated. As su ch it m ay fall on a non-
bu siness day – su ch as a w eek end or pu blic holiday . The settlem ent date is
the day on w hich the transaction settles or clears, and so can only fall on a
w ork ing day .
Figure 2.9 Classic repo transaction.
A seller in a repo transaction is entering into a repo, w hereas a bu y er

is entering into a reverse repo. In Figu re 2.9 the repo cou nterparty
is Bank A, w hile Bank B is entering into a rev erse repo. That is, a
rev erse repo is a pu rchase of secu rities that are sold back on term ina-
tion. As is ev ident from Figu re 2.9, ev ery repo is a rev erse repo, and
the nam e giv en is dependent on from w hose v iew point one is look ing
at the transaction. 9
Ex am ples of classic repo

The basic principle is illu strated w ith the follow ing ex am ple. This
considers a specific repo – that is, one in w hich the collateral su pplied
is specifi ed as a particu lar stock – as opposed to a general collateral
(GC) trade in w hich a bask et of collateral can be su pplied, of any
particu lar issu e, as long as it is of the requ ired ty pe and credit qu ality .
We fi rst consider a classic repo in the UK gilt m ark et betw een
tw o m ark et cou nterparties, in the 5.75% Treasu ry 2012 gilt stock
as at 2 Decem ber 2005. The term s of the trade are giv en in Table 2.2
and the trade is illu strated in Figu re 2.10.
Note that the gu idelines to the sy llabu s for the Chartered Financial
Analy st ex am ination, w hich is set by the Association for Inv estm ent
Managem ent and Research, defi nes repo and rev erse repo slightly differ-
ently . Essentially , a ‘repo’ is condu cted by a bank cou nterparty and a
‘rev erse repo’ is condu cted by an inv estm ent cou nterparty or non-fi nancial
cou nterparty . Another defi nition states that a ‘repo’ is any trade w here the
bank cou nterparty is offering stock (borrow ing cash) and a ‘rev erse repo’ is
any trade w here the non-bank cou nterparty is borrow ing cash. The au thor
does not m ak e this distinction; by defi nition ev ery repo is a ‘rev erse repo’
for the other side.
Table 2.2 Term s of a classic repo trade
Trade date 2 Decem ber 2005

Valu e date 5 Decem ber 2005
Repo term 1 m onth
Term ination date 5 Janu ary 2006
Collateral (stock ) UKT 5% 2012
Nom inal am ou nt £10,000,000
Price 104.17
Accru ed interest (89 day s) 1.229 281 8
Dirty price 105.3993
Haircu t 0%
Settlem ent proceeds (wired amount) £10,539,928.18
Repo rate 4.50%
Repo interest £40,282.74
Term ination proceeds £10,580,210.92
The repo cou nterparty deliv ers to the rev erse repo cou nterparty
£10 m illion nom inal of the stock , and in retu rn receiv es the pu rchase
proceeds. In this ex am ple no m argin has been tak en, so the start
proceeds are equ al to the m ark et v alu e of the stock w hich is
£10,539,928. It is com m on for a rou nded su m to be transferred on
the opening leg. The repo interest is 4.50% , so the repo interest
charged for the trade is:
7
10,539,928 4 50%
365
or £40,282.74. The sterling m ark et day -cou nt basis is actu al/365, so
the repo interest is based on a 7-day repo rate of 4.50% . Repo rates are
agreed at the tim e of the trade and are qu oted, lik e all interest rates,
on an annu alized basis. The settlem ent price (dirty price) is u sed
Figure 2.10 Classic repo trade.

becau se it is the m ark et v alu e of the bonds on the particu lar trade
date and therefore indicates the cash v alu e of the gilts. By doing this,
the cash inv estor m inim izes credit ex posu re by equ ating the v alu e of
the cash and the collateral.
On term ination the repo cou nterparty receiv es back its stock , for
w hich it hands ov er the original proceeds plu s the repo interest
calcu lated abov e.
Mark et participants w ho are fam iliar w ith the Bloom berg LP trading
sy stem w ill u se screen RRRA for a class ic repo transaction. For this
ex am ple the relev ant screen entries are show n at Figu re 2.11. This
screen is u sed in conju nction w ith a specifi c stock , so in this case it
w ou ld be called u p by entering:
UKT 5 12 GOVT RRRA GO
w here ‘UKT’ is the tick er for UK gilts. Note that the date form at for
Bloom berg screens is m m /dd/y y . The screen inpu ts are relativ ely
self-ex planatory , w ith the u ser entering the term s of the trade that
are detailed in Table 2.2. There is also a fi eld for calcu lating m argin,
labelled ‘collateral’ on the screen. As no m argin is inv olv ed in this
ex am ple, it is left at its defau lt v alu e of 100.00% . The bottom of the
Figure 2.11 Bloom berg screen RRRA for classic repo.

Bloom berg Finance L.P. All rights reserv ed. Used w ith perm ission.
Figure 2.12 HBOS repo rates screen as at 2 Decem ber 2005.

screen show s the opening leg cash proceeds or ‘w ired am ou nt’, the
repo interest and the term ination proceeds.
The repo rate for the trade is the 1-m onth rate of 4.50% , as show n in
Figu re 2.12, w hich is the HBOS repo rates screen as at 2 Decem ber
2005. 10
What if a cou nterparty is interested in inv esting £10 m illion against

gilt collateral? Let u s assu m e that a corporate treasu ry fu nction w ith
su rplu s cash w is hes to inv est this am ou nt in repo for a 1-w eek term .
It inv ests this cash w ith a bank that deals in gilt repo. We can u se
Bloom berg screen RRRA to calcu late the nom inal am ou nt of col-
lateral requ ired. Figu re 2.13 show s the screen for this trade, again
against the 5.75% Treasu ry 2012 stock as collateral. We see from
Figu re 2.13 that the term s of the trade are identical to those in Table
2.2, inclu ding the tenor and the repo rate; how ev er, the opening leg
w ired am ou nt is entered as £10 m illion, w hich is the cash being
The au thor u sed to deal w ith Leeds Perm anent Bu ilding Society , w hose
rates screen he m ade u se of in the early 1990s. This becam e Halifax plc and
then HBOS. Sadly , these entities are no longer w ith u s, bu t the HBOS
screen has been retained for nostalgic reasons.
Figure 2.13 Bloom berg screen for classic repo trade described on
this page.
inv ested. Therefore, the nom inal v alu e of the gilt collateral requ ired
w ill be different, as w e now requ ire a m ark et v alu e of this stock of
£10 m illion. From the screen w e see that this is £9,487,773.00. The
cash am ou nt is different from the ex am ple at Figu re 2.14, so of cou rse
the repo interest charged is different and is £38,219.18 for the 1-
m onth term .
The diagram at Figu re 2.14 illu strates the transaction.
The sell/buy back

In addition to classic repo, there ex ists sell/buyback. A sell/bu y back
is defi ned as an ou tright sale of a bond on the v alu e date, and
an ou tright repu rchase of that bond for v alu e on a forward date.
The cashfl ow s therefore becom e a sale of the bond at the spot
price, follow ed by repu rchas e of the bond at the forward price.
The forw ard price calcu lated inclu des interest on the repo, and is
therefore a different price to the spot price. That is, repo interest is
realized as the difference betw een the spot price and forw ard price of
the collateral at the start and term ination of the trade. The sell/
Figure 2.14 Corporate treasu ry classic repo, as illu strated in

Figu re 2.13.
bu y back is entered into for the sam e considerations as a class ic repo,

bu t w as dev eloped initially in m ark ets w here there is no legal agree-
m ent to cov er repo transactions , and w here the settlem ent and IT
sy stem s of indiv idu al cou nterparties w ere not equ ipped to deal w ith
repo. Ov er tim e sell/bu y back s hav e becom e the conv ention in
certain m ark ets, m ost notably Italy , and so the m echanism is still
retained. In m any m ark ets, therefore, sell/bu y back s are not cov ered
by a legal agreem ent, althou gh the standard legal agreem ent u s ed in
class ic repo now inclu des a section that describes them . 11
A sell/bu y back is a spot sale and forw ard repu rchas e of bonds
transacted sim u ltaneou s ly , and the repo rate is not ex plicit, bu t is
im plied in the forw ard price. Any cou pon pay m ents du ring the
term are paid to the seller; how ev er, this is done throu gh incor-
poration into the forw ard price, so the seller w ill not receiv e it
im m ediately , bu t on term ination. This is a disadv antage w hen com -
pared w ith classic repo. How ev er, there w ill be com pensation
pay able if a cou pon is not handed ov er straight aw ay , u su ally at
the repo rate im plied in the sell/bu y back . As sell/bu y back s are
not su bject to a legal agreem ent in m ost cases, in effect the seller
has no legal right to any cou pon, and there is no prov ision for
m ark ing to m ark et and variation margin. This m ak es the sell/
bu y back a higher risk transaction w hen com pared w ith classic
repo, ev en m ore so in v olatile m ark ets.
A general diagram for the sell/bu y back is giv en at Figu re 2.15.
This is the PSA/ISMA Global Master Repu rchase Agreem ent, w hich is
rev iew ed in the au thor’s book Introduction to Repo Markets, 3rd edition,
part of this series by John Wiley & Sons.
Figure 2.15 Sell/bu y -back transaction.
Ex am ples of sell/buy back

We u se the sam e term s of trade giv en in the prev iou s section, bu t this
tim e the trade is a sell/bu y back .12 In a sell/bu y back w e requ ire the
forw ard price on term ination, and the difference betw een the spot
and forw ard price incorporates the effects of repo interest. It is
im portant to note that this forw ard price has nothing to do w ith
the actu al m ark et price of the collateral at the tim e of forw ard trade.
It is sim ply a w ay of allow ing for the repo interest that is the k ey
factor in the trade. Thu s, in sell/bu y back the repo rate is not ex plicit
(althou gh it is the k ey consideration in the trade), rather it is im plicit
in the forw ard price.
In this ex am ple, one cou nterparty sells £10 m illion nom inal of the
UKT 5% 2012 at the spot price of 104.17, this being the m ark et price
of the bond at the tim e. The consideration for this trade is the m ark et
v alu e of the stock , w hich is £10,539,928.18 as before. Repo interest is
calcu lated on this am ou nt at the rate of 4.50% for 1 m onth, and from
this the term ination proceeds are calcu lated. The term ination pro-
ceeds are div ided by the nom inal am ou nt of stock to obtain the
forw ard dirty price of the bond on the term ination date. For v ariou s
reasons – the m ain one being that settlem ent sy stem s deal in clean
prices – w e requ ire the forw ard clean price, w hich is obtained by
su btracting the accru ed interest on the bond on the term ination date
The Bank of England discou rages sell/bu y back s in the gilt repo and it is
u nu su al to observ e them in this m ark et. How ev er, w e u se these term s of
trade for com parison w ith the classic repo ex am ple giv en in the prev iou s
section.
Figure 2.16 Bloom berg screen BSR for sell/bu y back trade in 5%
2012.
from the forw ard dirty price. At the start of the trade, the 5% 2012
had 89 day s’ accru ed interest, therefore on term ination this fi gu re
w ill be 89 31 or 120 day s.
Bloom berg u sers access a different screen for sell/bu y back s, w hich is
BSR. This is show n at Figu re 2.16. Entering in the term s of the trade,
w e see from Figu re 2.16 that the forw ard price is 104.144. How ev er,
the fu ndam ental elem ent of this transaction is ev ident from the
bottom part of the screen: the settlem ent am ou nt (‘w ired
am ou nt’), repo interest and term ination am ou nt are identical to
the classic repo trade described earlier. This is not su rprising; the
sell/bu y back is a loan of £10.539 m illion for 1 m onth at an interest
rate of 4.50% . The m echanics of the trade do not im pact on this k ey
point.
Screen BSR on Bloom berg has a second page, w hich is show n at

Figu re 2.17. This screen su m m arizes the cash proceeds of the trade
at start and term ination. Note how repo interest is term ed ‘fu nding
cost’. This is becau se the trade is deem ed to hav e been entered into
by a bond-trader w ho is fu nding his book . This w ill be considered
Figure 2.17 Bloom berg screen BSR page 2 for sell/bu y back trade in
5.75% 2009.
later, bu t w e can see from the screen details that du ring the 1 m onth
of the trade the bond position has accru ed interest of £165,745.00.
This com pares fav ou rably w ith the repo fu nding cost of £122,928.18.
The fu nding cost is therefore below the accru ed interest gained on
the bondholding, as show n in the screen.
If there is a cou pon pay m ent du ring a sell/bu y back trade and it is not
paid ov er to the seller u ntil term ination, a com pensating am ou nt is
also pay able on the cou pon am ou nt, u su ally at the trade’ s repo
rate. When calcu lating the forw ard price on a sell/bu y back w here
a cou pon w ill be paid du ring the trade, w e m u st su btract the cou pon
am ou nt from the forw ard price. Note also that sell/bu y back s are not
possible on an open basis, as no forw ard price can be calcu lated
u nless a term ination date is k now n.
Repo collateral
The collateral in a repo trade is the secu rity passed to the lender
of cash by the borrow er of cash. It is not alw ay s secondary to the
transaction; in stock -driv en transactions the requ irem ent for

specifi c collateral is the m otiv ation behind the trade. How ev er, in
a classic repo or sell/bu y back , the collateral is alw ay s the secu rity
handed ov er against cash. 13 In a stock loan transaction, the collateral
against stock lent can be either secu rities or cash. Collateral is u sed
in repo to prov ide secu rity against defau lt by the cash borrow er.
Therefore, it is protection against cou nterparty risk or credit risk,
the risk that the cash-borrow ing cou nterparty defau lts on the loan.
A secu red or collateralized loan is theoretically low er credit risk
ex posu re for a cash lender com pared w ith an u nsecu red loan.
The m ost com m only encou ntered collateral is gov ernm ent bonds ,
and the repo m ark et in gov ernm ent bonds is the largest in the
w orld. Other form s of collateral inclu de Eu robonds, other form s of
corporate and su pranational debt, asset-back ed bonds, m ortgage-
back ed bonds , m oney m ark et secu rities su ch as T-bills, and equ ities.
In any m ark et w here there is a defi ned class of collateral of

identical credit qu ality , this is k now n as general collateral (G C ).
So, for ex am ple, in the UK gilt m ark et a GC repo is one w here any gilt
w ill be acceptable as repo collateral. Another form of GC m ight be
‘AA-rated sterling Eu robonds ’. In the US m ark et the term stock
collateral is som etim es u sed to refer to GC secu rities. In equ ity
repo it is m ore problem atic to defi ne GC and by defi nition alm ost
all trades are specifi cs ; how ev er, it is becom ing m ore com m on for
cou nterparties to specify any equ ity being acceptable if it is in an
established index – for ex am ple, a FTSE 100 or a CAC 40 stock – and
this is perhaps the equ ity m ark et equ iv alent of GC. If a specifi c
secu rity is requ ired in a rev erse repo or as the other side of a sell/
bu y back , this is k now n as a specific or specific collateral. A specifi c
stock that is in high dem and in the m ark et, su ch that the repo rate
against it is signifi cantly different from the GC rate, is k now n as a
special.
Where a cou pon pay m ent is receiv ed on collateral du ring the term of
a repo, it is to the benefi t of the repo seller. Under the standard repo
legal agreem ent, legal title to collateral is transferred to the bu y er
du ring the term of the repo, bu t it is accepted that the econom ic
benefi ts rem ain w ith the seller. For this reason, cou pon is retu rned
to the seller. In class ic repo (and in stock lending) the cou pon is
So that ev en in a stock -driv en rev erse repo the collateral is the secu rity
handed ov er against the borrow ing of cash by the repo seller.
retu rned to the seller on the div idend date, or in som e cases on the
follow ing date. In a sell/bu y back the effect of the cou pon is incorpo-
rated in the repu rchas e price. This inclu des interest on the cou pon
am ou nt that is pay able by the bu y er du ring the period from the
cou pon date to the bu y back date.
Legal treatm ent

Classic repo is carried ou t u nder a legal agreem ent that defi nes the
transaction as a fu ll transfer of the title to the stock . The standard
legal agreem ent is the PSA/ISMA GRMA, w hich w e rev iew in the
sister book in this series, An Introduction to Repo Markets. It is
now possible to trade sell/bu y back s u nder this agreem ent as w ell.
This agreem ent w as based on the PSA standard legal agreem ent u sed
in the US dom estic m ark et, and w as com piled becau se certain
fi nancial institu tions w ere not allow ed to legally borrow or lend
secu rities. By transacting repo u nder the PSA agreem ent, these
institu tions w ere defi ned as legally bu y ing and selling secu rities
rather than borrow ing or lending them .
Margin
To redu ce the lev el of risk ex posu re in a repo transaction, it is
com m on for the lender of cash to ask for a m argin, w hich is
w here the m ark et v alu e of collateral is higher than the cash v alu e
of cash lent ou t in the repo. This is a form of protection, shou ld the
cash-borrow ing cou nterparty defau lt on the loan. Another term for
m argin is overcollateralization or a haircut. There are tw o ty pes of
m argin: initial margin tak en at the start of the trade and variation
margin w hich is called if requ ired du ring the term of the trade.
Initial margin
The cash proceeds in a repo are ty pically no m ore than the m ark et
v alu e of the collateral. This m inim izes credit ex posu re by equ ating
the v alu e of the cash to that of the collateral. The m ark et v alu e of the
collateral is calcu lated at its dirty price, not clean price – that is,
inclu ding accru ed interest. This is referred to as accrual pricing.
To calcu late the accru ed interest on the (bond) collateral w e
requ ire the day -cou nt basis for the particu lar bond.
The start proceeds of a repo can be less than the m ark et v alu e of the
collateral by an agreed am ou nt or percentage. This is k now n as the
initial margin or haircut. The initial m argin protects the bu y er
against
a su dden fall in the m ark et v alu e of the collateral;

illiqu idity of collateral;
other sou rces of v olatility of v alu e (e.g., approaching m atu rity );
cou nterparty risk .
The m argin lev el of repo v aries from 0% –2% for collateral su ch as

UK gilts to 5% for cross-cu rrency and equ ity repo, to 10% –35% for
em erging m ark et debt repo.
In both class ic repo and sell/bu y back , any initial m argin is giv en to
the su pplier of cash in the transaction. This rem ains the case in the
case of specifi c repo. For initial m argin the m ark et v alu e of the bond
collateral is redu ced (or giv en a haircut) by the percentage of the
initial m argin and the nom inal v alu e determ ined from this redu ced
am ou nt. In a stock loan transaction the lender of stock w ill ask for
m argin.
There are tw o m ethods for calcu lating m argin; for a 2% m argin this
cou ld be one of the follow ing:
the dirty price of the bonds 0.98;

the dirty price of the bonds 1.02.
The tw o m ethods do not giv e the sam e v alu e! The RRRA repo page
on Bloom berg u ses the second m ethod for its calcu lations , and this
m ethod is tu rning into som ething of a conv ention.
For a 2% m argin lev el the PSA/ISMA GRMA defi nes a ‘m argin ratio’
as:
Collateral v alu e
102%
Cash
The size of m argin requ ired in any particu lar transaction is a

fu nction of the follow ing:
the credit qu ality of the cou nterparty su pply ing the collateral –
for ex am ple, a central bank cou nterparty , interbank cou nterparty
and corporate w ill all su ggest different m argin lev els;
the term of the repo – an ov ernight repo is inherently low er risk

than a 1-y ear repo;
the du ration (price v olatility ) of the collateral – for ex am ple, a
T-bill against the long bond;
the ex istence or absence of a legal agreem ent – a repo traded u nder
a standard agreem ent is considered low er risk .
How ev er, in the fi nal analy sis, m argin is requ ired to gu ard against
m ark et risk , the risk that the v alu e of collateral w ill drop du ring the
cou rse of the repo. Therefore, the m argin call m u st refl ect the risk s
prev alent in the m ark et at the tim e; ex trem ely v olatile m ark et
conditions m ay call for large increases in initial m argin.
Variation m argin
The m ark et v alu e of collateral is m aintained throu gh the u se of
variation margin. So, if the m ark et v alu e of collateral falls, the
bu y er calls for ex tra cash or collateral. If the m ark et v alu e of
collateral rises, the seller calls for ex tra cash or collateral. In order
to redu ce the adm inistrativ e bu rden, m argin calls can be lim ited to
changes in the m ark et v alu e of collateral in ex cess of an agreed
am ou nt or percentage, w hich is called a margin maintenance
limit.
The standard m ark et docu m entation that ex ists for the three
stru ctu res cov ered so far inclu des clau ses that allow parties to a
transaction to call for v ariation m argin du ring the term of a repo.
This can be in the form of ex tra collateral, if the v alu e of collateral
has dropped in relation to the asset ex changed, or a retu rn of col-
lateral, if the v alu e has risen. If the cash-borrow ing cou nterparty is
u nable to su pply m ore collateral w here requ ired, he w ill hav e to
retu rn a portion of the cash loan. Both parties hav e an interest in
m ak ing and m eeting m argin calls, althou gh there is no obligation.
The lev el at w hich v ariation m argin is triggered is often agreed
beforehand in the legal agreem ent pu t in place betw een indiv idu al
cou nterparties. Althou gh prim arily v iew ed as an instru m ent u sed by
the su pplier of cash against a fall in the v alu e of the collateral,
v ariation m argin can of cou rse also be called by the repo seller if
the v alu e of the collateral has risen.
CURRENCIES USING MONEY MARKET

YEAR BASE OF 365 DAYS
Sterling;
Hong Kong dollar;
Malay sian ringgit;
Singapore dollar;
Sou th African rand;
Taiw an dollar;
Thai baht.
In addition, the dom estic m ark ets, bu t not the international m ark ets,
of the follow ing cu rrencies also u se a 365-day base:
Au stralian dollar;
Canadian dollar;
Japanese y en;
New Zealand dollar.
To conv ert an interest rate i qu oted on a 365-day basis to one qu oted
on a 360-day basis i u se the ex pressions giv en at (2.15):
365
i i
360
2 15
360
i i
365
By Moorad Choudhry
Chapter
3
THE YIELD CURVE
U nderstanding and appreciating the y ield cu rv e is im portant to

all capital m ark et participants. It is especially im portant to
debt capital m ark et participants , and ev en m ore especially im portant
to bank ALM practitioners. So for any one reading this book it is safe
to assu m e that the y ield cu rv e is a v ery im portant su bject! This is a
long chapter bu t w ell w orth getting to grips w ith. In it, w e discu s s
the basic concepts of the y ield cu rv e, as w ell as its u ses and inter-
pretation. We show how to calcu late the zero-cou pon (or spot) and
forw ard y ield cu rv e, and present the m ain theories that seek to
ex plain its shape and behav iou r. We w ill see that the spread of
one different cu rv e to another, su ch as the sw ap cu rv e com pared
w ith the gov ernm ent cu rv e, is itself im portant. We begin w ith an
introdu ction to the cu rv e and interest rates.
Im portance of the y ield curve

Bank s deal in interest rates and credit risk . Thes e are the tw o
fu ndam ental tenets of bank ing – ju st as fu ndam ental today as
they w ere w hen bank ing fi rst began. The fi rst of these – interest
rates – is an ex plicit m easu re of the cost of borrow ing m oney and is
encapsu lated in the y ield cu rv e. For bank ers, u nderstanding the
behav iou r and properties of the y ield cu rv e is an essential part of
the ALM process. The follow ing are som e, bu t not all, of the reasons
that this is so:
changes in interest rates hav e a direct im pact on bank rev enu e;
the y ield cu rv e captu res the cu rrent state of term interest rates
and also presents the cu rrent m ark et ex pectation of fu tu re
interest rates;
the interest rate gap refl ects the state of bank borrow ing and
lending; gaps along the term stru ctu re are sensitiv e to changes
in the shape and slope of the y ield cu rv e;
cu rrent and fu tu re trading strategy , inclu ding the asset allocation
and credit policy decision, w ill im pact interest rate risk ex posu re
and therefore w ill tak e into accou nt the shape and behav iou r of
the y ield cu rv e.
We can see then that u nderstanding and appreciating the y ield cu rv e

is a v ital part of ALM operations. This chapter is a detailed look at the
cu rv e from the bank er’s v iew point.
The y ield cu rv e is an im portant indicator and k now ledge sou rce of
the state of a debt capital m ark et. It is som etim es referred to as the
THE YIELD CURVE 69
term structure of interest rates, bu t strictly speak ing this is not

correct, as this term shou ld be reserv ed for the zero-cou pon y ield
cu rv e only . Bu t w e don’t need to w orry abou t this.
The analy sis and pricing activ ity that tak es place in fi nancial
m ark ets rev olv es arou nd the y ield cu rv e. The y ield cu rv e describes
the relationship betw een a particu lar y ield and its term to m atu rity .
So, plotting y ields of a set of bonds along the m atu rity stru ctu re w ill
giv e u s ou r y ield cu rv e. The prim ary y ield cu rv e in any dom estic
capital m ark et is the gov ernm ent bond y ield cu rv e – for ex am ple, in
the US m ark et it is the US Treasu ry y ield cu rv e. Ou ts ide gov ernm ent
bond m ark ets, y ield cu rv es are plotted for Eu robonds, m oney m ark et
instru m ents , off-balance-sheet instru m ents – in fact, v irtu ally all
debt m ark et instru m ents . So, it is alw ay s im portant to rem em ber
to com pare lik e for lik e w hen analy sing y ield cu rv es across m ark ets.
Using the y ield curve

The y ield cu rv e tells u s w here the bond m ark et is trading now . It also
im plies the lev el of trading for the fu tu re, or at least w hat the m ark et
think s w ill be happening in the fu tu re. In other w ords, it is a good
indicator of the fu tu re lev el of the m ark et. It is also a m u ch m ore
reliable indicator than any other u sed by priv ate inv estors, and w e
can prov e this em pirically . Bu t, for the m om ent tak e m y w ord for it!
As an introdu ction to y ield cu rv e analy sis, let u s fi rst consider its
m ain u ses. All participants in debt capital m ark ets w ill be interested
in the cu rrent shape and lev el of the y ield cu rv e, as w ell as w hat this
inform ation im plies for the fu tu re. The m ain u ses are su m m arized
below .
Setting the yield for all debt market instruments. The y ield cu rv e
essentially fi x es the price of m oney ov er the m atu rity stru ctu re. The
y ields of gov ernm ent bonds from the shortest m atu rity instru m ent
to the longest set the benchm ark for y ields for all other debt instru -
m ents in the m ark et, arou nd w hich all debt instru m ents are priced.
What does this m ean? Essentially , it m eans that if a gov ernm ent
5-y ear bond is trading at a y ield of 5.00% , all other 5-y ear bonds ,
w hoev er they are issu ed by , w ill be issu ed at a y ield ov er 5.00% . The
am ou nt ov er 5.00% that the other bond trades is k now n as the
spread. Therefore, issu ers of debt u se the y ield cu rv e to price
bonds and all other debt instru m ents . Generally , the zero-cou pon
y ield cu rv e is u sed to price new -iss u e secu rities, rather than the
redem ption y ield cu rv e.
Acting as an indicator of future yield levels. As w e discu ss later in

this chapter, the y ield cu rv e assu m es certain shapes in response to
m ark et ex pectations of fu tu re interest rates. Bond m ark et partici-
pants analy se the present shape of the y ield cu rv e in an effort to
determ ine im plications regarding the direction of m ark et interest
rates. This is perhaps one of the m ost im portant fu nctions of the
y ield cu rv e. Interpreting it is a m ix tu re of art and science. The y ield
cu rv e is scru tinized for its inform ation content not ju st by bond
traders and fu nd m anagers bu t also by corporate fi nanciers as part
of their project appraisals. Central bank s and gov ernm ent Treasu ry
departm ents also analy se the y ield cu rv e for its inform ation content,
not ju st regarding forw ard interest rates bu t also infl ation lev els.
They then u se this inform ation w hen setting interest rates.
Measuring and comparing returns across the maturity spectrum.

Portfolio m anagers u se the y ield cu rv e to asses s the relativ e v alu e
of inv estm ents across the m atu rity spectru m . The y ield cu rv e
indicates retu rns that are av ailable at different m atu rity points
and is therefore v ery im portant to fi x ed interest fu nd m anagers,
w ho can u se it to assist them to assess w hich point of the cu rv e
offers the best retu rn relativ e to other points.
Indicating the relative value between different bonds of similar

maturity. The y ield cu rv e can be analy sed to indicate w hich
bonds are ‘cheap’ or ‘dear’ (ex pensiv e) to the cu rv e. Placing bonds
relativ e to the zero-coupon yield curve helps to highlight w hich
bonds shou ld be bou ght or sold, either ou tright or as part of a
bond spread trade.
Pricing interest rate derivative instruments. The price of deriv ativ es

su ch as fu tu res and sw aps rev olv es arou nd the y ield cu rv e. At the
shorter end, produ cts su ch as forw ard rate agreem ents are priced off
the fu tu res cu rv e, bu t fu tu res rates refl ect the m ark et’s v iew on
forw ard 3-m onth cash deposit rates. At the longer end, interest
rate sw aps are priced off the y ield cu rv e, w hile hy brid instru m ents
that incorporate an option featu re su ch as conv ertibles and callable
bonds also refl ect cu rrent y ield cu rv e lev els. The ‘risk -free’ interest
rate – one of the param eters u sed in option pricing – is the T-bill rate
or short-term gov ernm ent repo rate, both constitu ents of the m oney
m ark et y ield cu rv e.
THE YIELD CURVE 71
Yield-to-m aturity y ield curve

Yield curve shapes
The m ost com m only occu rring y ield cu rv e is the y ield-to-m atu rity
y ield cu rv e. The process of calcu lating a debt instru m ent’s y ield to
m atu rity is described in cou ntles s fi nance tex tbook s. The cu rv e itself
is constru cted by plotting y ield to m atu rity against term to m atu rity
for a grou p of bonds of the sam e class.
Cu rv es assu m e m any different shapes; Figu re 3.1 show s three hy -

pothetical ty pes. Bonds u sed in constru cting the cu rv e w ill only
rarely hav e an ex act nu m ber of w hole y ears to redem ption;
how ev er, it is often com m on to see y ields plotted against w hole
y ears on the x-ax is. This is becau se once a bond is designated the
benchmark for that term , its y ield is tak en to be the representativ e
y ield. A bond loses benchm ark statu s once a new benchm ark for that
m atu rity is issu ed.
The y ield-to-m atu rity y ield cu rv e is the m ost com m only observ ed
cu rv e sim ply becau se y ield to m atu rity is the m ost frequ ent m easu re
of retu rn u s ed. The bu s iness sections of daily new spapers – if they
qu ote bond y ield at all – u su ally qu ote bond y ields to m atu rity .
The y ield-to-m atu rity y ield cu rv e contains som e inaccu racies. This
is becau se the y ield-to-m atu rity m easu re has one large w eak nes s: the
Figure 3.1 Yield-to-m atu rity y ield cu rv es.

assu m ption of a constant discou nt rate for cou pons du ring the bond’s
life at the redem ption y ield lev el. In other w ords, w e discou nt all the
cashfl ow s of the bond at one discou nt rate. This is not a realistic
assu m ption to m ak e becau se w e k now , ju st as night follow s day , that
interest rates in 6 m onth’s tim e (u sed to discou nt the cou pon du e in
6 m onths) w ill not be the sam e as the interest rate prev ailing in
2 y ears’ tim e (u sed to discou nt the 2-y ear cou pon). Bu t w e m ak e this
assu m ption, nev ertheless – for the sak e of conv enience. How ev er,
the u pshot of all this is that redem ption y ield is not the tru e interest
rate for its particu lar m atu rity .
By the w ay , this giv es rise to a featu re k now n as reinvestment risk:
the risk that – w hen w e reinv es t each bond cou pon as it is paid – the
interest rate at w hich w e inv est it w ill not be the sam e as the
redem ption y ield prev ailing on the day w e bou ght the bond. We
m u st accept this risk , u nless w e bu y a strip or zero-coupon bond.
Only zero-cou pon bondholders av oid reinv es tm ent risk as no cou pon
is paid du ring the life of their bond.
For the reasons w e hav e discu s sed, the professional w holesale
m ark et often u ses other ty pes of y ield cu rv e for analy sis w hen the
y ield-to-m atu rity y ield cu rv e is deem ed u nsu itable – u su ally , the
zero-cou pon y ield cu rv e. This is the y ield cu rv e constru cted from
zero-cou pon y ields ; it is also k now n as the term stru ctu re of interest
rates. We constru ct a zero-cou pon cu rv e from bond prices and re-
dem ption y ields .
Analy sing and interpreting the y ield curve

From observ ing y ield cu rv es in different m ark ets at any tim e, w e
notice that a y ield cu rv e can adopt one of fou r basic shapes:
normal or conventional – in w hich y ields are at ‘av erage’ lev els
and the cu rv e slopes gently u pw ards as m atu rity increases;
upward-sloping or positive or rising – in w hich y ields are at
historically low lev els, w ith long rates su bstantially greater
than short rates;
downward-sloping or inverted or negative – in w hich y ield lev els
are v ery high by historical standards, bu t long-term y ields are
signifi cantly low er than short rates;
humped – w here y ields are high w ith the cu rv e rising to a peak in
the m ediu m -term m atu rity area, and then sloping dow nw ards at
longer m atu rities.
THE YIELD CURVE 73
Som etim es y ield cu rv es incorporate a m ix tu re of the abov e featu res.

A great deal of effort is spent by bond analy sts and econom ists
analy sing and interpreting y ield cu rv es. There is considerable
inform ation content associated w ith any cu rv e at any tim e.
The v ery ex istence of a y ield cu rv e indicates that there is a cost
associated w ith fu nds of different m atu rities, otherw ise w e w ou ld
observ e a fl at y ield cu rv e. The fact that w e v ery rarely observ e
any thing approaching a fl at y ield cu rv e su ggests that inv estors
requ ire different rates of retu rn depending on the m atu rity of the
instru m ent they are holding. In the nex t section w e w ill consider the
v ariou s ex planations that hav e been pu t forw ard to ex plain the shape
of the y ield cu rv e at any one tim e. Why do w e need to do this?
Becau se an u nderstanding of w hy the y ield cu rv e assu m es certain
shapes w ill help u s u nderstand the inform ation that a certain shape
im plies.
None of the theories can adequ ately ex plain ev ery thing abou t y ield
cu rv es and the shapes they assu m e at any tim e, so generally
observ ers seek to ex plain specifi c cu rv es u sing a com bination of
accepted theories.
Theories of the y ield curve

No one m athem atical ex planation of the y ield cu rv e ex plains its
shape at all tim es. At the sam e tim e, som e ex planations are m u tu ally
ex clu siv e. That said, practitioners often seek to ex plain the shape of a
cu rv e by recou rse to a m ix tu re of theories.
The expectations hypothesis

The expectations hypothesis su ggests that bondholder ex pectations
determ ine the cou rse of fu tu re interest rates. There are tw o m ain
com peting v ersions of this hy pothesis, the local expectations
hypothesis and the unbiased expectations hypothesis. The return-
to-maturity expectations hy pothesis and yield-to-maturity expecta-
tions hy pothesis are also qu oted (see Ingers oll, 1987). The local
ex pectations hy pothesis states that all bonds of the sam e class –
bu t differing in term to m atu rity – w ill hav e the sam e ex pected
holding period rate of retu rn. This su ggests that a 6-m onth bond
and a 20-y ear bond w ill produ ce the sam e rate of retu rn, on
av erage, ov er the stated holding period. So, if w e intend to hold a
bond for 6 m onths, w e w ill get the sam e retu rn no m atter w hat
specifi c bond w e bu y . The au thor feels that this theory is not alw ay s
the case, despite being m athem atically neat; how ev er, it is w orth
spending a few m om ents discu s sing it and related points. Generally ,
holding period returns from longer dated bonds are on av erage higher
than those from short-dated bonds. Intu itiv ely , w e w ou ld ex pect
this, w ith longer dated bonds offering higher retu rns to com pensate
for their higher price v olatility (risk ). The local ex pectations hy poth-
esis w ou ld not agree w ith the conv entional belief that inv estors,
being risk -av ers e, requ ire higher retu rns as a rew ard for tak ing on
higher risk ; in addition, it does not prov ide any insight into the shape
of the y ield cu rv e. Essentially thou gh, in theory one shou ld ex pect
that the retu rn from holding any bond for a 6-m onth period w ill be
the sam e irrespectiv e of the term to m atu rity and y ield that the bond
has at tim e of pu rchase.
In his ex cellent book Modelling Fixed Income Securities Professor

Robert Jarrow (1996, p. 50) states
‘ in an econom ic equ ilibriu m , the retu rns on sim ilar m atu rity
zero-cou pon bonds cannot be too different. If they w ere too dif-
ferent, no inv estor w ou ld hold the bond w ith the sm aller retu rn.
This difference cou ld not persist in an econom ic equ ilibriu m .’
This is tru e, bu t in practice other factors can im pact holding period

retu rns betw een bonds that do not hav e sim ilar m atu rities. For
instance, inv estors hav e restrictions as to w hich bonds they can
hold – for ex am ple, bank s and bu ilding societies are requ ired to
hold short-dated bonds for liqu idity pu rposes. In an env ironm ent
of econom ic disequ ilibriu m , these inv estors w ou ld still hav e to
hold shorter dated bonds , ev en if the holding period retu rn w as low er.
This is noted by Mark Ru binstein (1999, pp. 84–85) w ho states in his

book Rubinstein on D erivatives,
‘In the real w orld it is u su ally the case that annu alised shorter-
term risk less retu rns are low er than longer-term risk less retu rns
Real assets w ith shorter-term pay ou ts w ill tend to hav e a
‘‘liqu idity ’’ adv antage. In aggregate this adv antage w ill be
passed on to shorter-term fi nancial claim s on real assets [w hich
resu lts in them hav ing a low er retu rn].’
A related theory is the pure or unbiased expectations hypothesis,

w hich states that cu rrent im plied forw ard rates are u nbiased
THE YIELD CURVE 75
estim ators of fu tu re spot interest rates. 1 It assu m es that inv estors act
in a w ay that elim inates any adv antage of holding instru m ents of a
particu lar m atu rity . Therefore, if w e hav e a positiv e-sloping y ield
cu rv e, the u nbiased ex pectations hy pothesis states that the m ark et
ex pects spot interest rates to rise. Equ ally , an inv erted y ield cu rv e is
an indication that spot rates are ex pected to fall. If short-term inter-
est rates are ex pected to rise, then longer y ields shou ld be higher than
shorter ones to refl ect this. If this w ere not the case, inv estors w ou ld
only bu y the shorter dated bonds and roll ov er the inv estm ent w hen
they m atu red. Lik ew ise if rates are ex pected to fall then longer y ields
shou ld be low er than short y ields. The u nbiased ex pectations hy -
pothesis states that the long-term interest rate is a geom etric av erage
of ex pected fu tu re short-term rates.
Using elem entary m athem atics w e can prov e this theory . Indeed, its
prem ise m u st be so, to ensu re no arbitrage opportu nities ex ist in the
m ark et. The hy pothesis can be u sed to ex plain any shape in the y ield
cu rv e.
Therefore, a rising y ield cu rv e is ex plained by inv estors ex pecting
short-term interest rates to rise. A falling y ield cu rv e is ex plained
by inv estors ex pecting short-term rates to be low er in the fu tu re. A
hu m ped y ield cu rv e is ex plained by inv estors ex pecting short-term
interest rates to rise and long-term rates to fall. Expectations, or
v iew s on the fu tu re direction of the m ark et, are a fu nction m ainly
of the ex pected rate of infl ation. If the m ark et ex pects infl ationary
pressu res in the fu tu re, the y ield cu rv e w ill be positiv ely shaped,
w hile if infl ation ex pectations are inclined tow ards disinfl ation, then
the y ield cu rv e w ill be negativ e. Sev eral em pirical stu dies inclu ding
one by Fam a (1976) hav e show n that forw ard rates are essentially
biased predictors of fu tu re spot interest rates, and often ov erestim ate
fu tu re lev els of spot rates. The u nbiased hy pothesis has also been
criticized for su ggesting that inv estors can forecast (or hav e a v iew
on) v ery long-dated spot interest rates, w hich m ight be considered
slightly u nrealistic. As y ield cu rv es in m ost dev eloped cou ntry
m ark ets ex ist to a m atu rity of u p to 30 y ears or longer, su ch
criticism s m ay hav e som e su bstance. Are inv estors able to forecast
interest rates 10, 20 or 30 y ears into the fu tu re? Perhaps not, nev er-
theles s this is indeed the inform ation content of, say , a 30-y ear bond;
since the y ield on the bond is set by the m ark et, it is v alid to su ggest
For the original discu ssion, see Lu tz (1940) and Fisher (1986), althou gh the
latter form u lated his ideas earlier.
that the m ark et has a v iew on infl ation and fu tu re interest rates for
u p to 30 y ears forw ard.
The ex pectations hy pothesis is stated in m ore than one w ay ; w e
hav e already encou ntered the local ex pectations hy pothesis . Other
v ersions inclu de the return-to-maturity ex pectations hy pothesis,
w hich states that total retu rn from holding a zero-cou pon bond to
m atu rity w ill be equ al to total retu rn that is generated by holding a
short-term instru m ent and continu ou sly rolling it ov er the sam e
m atu rity period. A related v ersion – the yield-to-maturity
hy pothesis – states that the periodic retu rn from holding a zero-
cou pon bond w ill be equ al to the retu rn from rolling ov er a series
of cou pon bonds , bu t refers to annu alized retu rn earned each y ear
rather than total retu rn earned ov er the life of the bond. This
assu m ption enables a zero-cou pon y ield cu rv e to be deriv ed
from the redem ption y ields of cou pon bonds . The u nbiased ex -
pectations hy pothesis of cou rse states that forw ard rates are equ al
to the spot rates ex pected by the m ark et in the fu tu re. Cox , Ingers oll
and Ross (1981) su ggest that only the local ex pectations hy pothesis
describes a m odel that is pu rely arbitrage-free, as u nder the other
scenarios it w ou ld be possible to em ploy certain inv estm ent
strategies that w ou ld produ ce retu rns in ex cess of w hat w as
im plied by today ’s y ields . Althou gh it has been su ggested 2 that
differences betw een the local and u nbiased hy potheses are not
m aterial a m odel that describes su ch a scenario w ou ld not refl ect
inv estors’ beliefs, w hich is w hy fu rther research is requ ired in this
area.
The u nbiased ex pectations hy pothesis does not in itself ex plain all
the shapes of the y ield cu rv e or the inform ation content contained
w ithin it, w hich is w hy it is often com bined w ith other ex planations
w hen seek ing to ex plain the shape of the y ield cu rv e, inclu ding the
liqu idity preference theory .
Liquidity preference theory

Intu itiv ely , w e m ight feel that longer m atu rity inv estm ents are m ore
risk y than shorter ones. An inv estor lending m oney for a 5-y ear term
w ill u su ally dem and a higher rate of interest than if she w ere to lend
the sam e cu stom er m oney for a 5-w eek term . This is becau se the
borrow er m ay not be able to repay the loan ov er the longer tim e
For ex am ple, Cam pbell (1986) and Liv ingstone (1990).

THE YIELD CURVE 77
period as he m ay , for instance, hav e gone bank ru pt in that period. For

this reason longer dated y ields shou ld be higher than short-dated
y ields , to recom pens e the lender for higher risk ex posu re du ring the
term of the loan.3
We can consider this theory in term s of infl ation ex pectations as
w ell. Where infl ation is ex pected to rem ain rou ghly stable ov er tim e,
the m ark et w ou ld anticipate a positiv e y ield cu rv e. How ev er, the
ex pectations hy pothesis cannot in itself ex plain this phenom enon,
as u nder stable infl ationary conditions one w ou ld ex pect a fl at y ield
cu rv e. The risk inherent in longer dated inv estm ents , or the liquidity
preference theory, seek s to ex plain a positiv e-shaped cu rv e.
Generally , borrow ers prefer to borrow ov er as long a term as possible,
w hile lenders w ill w is h to lend ov er as short a term as possible.
Therefore, as w e fi rst stated, lenders hav e to be com pensated for
lending ov er the longer term ; this com pensation is considered a
prem iu m for a loss in liquidity for the lender. The prem iu m is
increased the fu rther the inv estor lends across the term stru ctu re,
so that longest dated inv estm ents w ill, all else being equ al, hav e the
highest y ield. So, the liqu idity preference theory states that the y ield
cu rv e shou ld alm os t alw ay s be u pw ard-sloping, refl ecting bond-
holders’ preference for the liqu idity and low er risk of shorter
dated bonds . An inv erted y ield cu rv e cou ld still be ex plained by
the liqu idity preference theory w hen it is com bined w ith the u n-
biased ex pectations hy pothesis. A humped y ield cu rv e m ight be
v iew ed as a com bination of an inv erted y ield cu rv e together w ith
a positiv e-sloping liqu idity preference cu rv e.
The difference betw een a y ield cu rv e ex plained by u nbiased
ex pectations and an actu al observ ed y ield cu rv e is som etim es re-
ferred to as the liquidity premium. This refers to the fact that in
som e cases short-dated bonds are easier to transact in the m ark et
than long-term bonds . It is diffi cu lt to qu antify the effect of the
liqu idity prem iu m , becau se it is not static and fl u ctu ates ov er
tim e. The liqu idity prem iu m is so called becau se, in order to
indu ce inv estors to hold longer dated secu rities, the y ields on
su ch secu rities m u st be higher than those av ailable on short-dated
secu rities, w hich are m ore liqu id and m ay be conv erted into cash
m ore easily . The liqu idity prem iu m is the com pensation requ ired for
holding less liqu id instru m ents . If longer dated secu rities then
prov ide higher y ields, as is su ggested by the ex istence of the liqu idity
For original discu ssion, see Hick s (1946).

prem iu m , they shou ld generate on av erage higher total retu rns

ov er an inv estm ent period. This is not consis tent w ith the local
ex pectations hy pothesis .
Segmentation hypothesis
Capital m ark ets are m ade u p of a w ide v ariety of u sers, each w ith
different requ irem ents. Certain classes of inv estors w ill prefer
dealing at the shorter end of the y ield cu rv e, w hile others w ill
concentrate on the longer end of the m ark et. The segmented
markets theory su ggests that activ ity is concentrated in certain
specifi c areas of the m ark et and that there are no interrelationships
betw een these parts of the m ark et; the relativ e am ou nts of fu nds
inv ested in each of the m atu rity spectra cau ses differentials in su pply
and dem and, w hich resu lts in hu m ps in the y ield cu rv e. That is, the
shape of the y ield cu rv e is determ ined by su pply and dem and for
certain specifi c m atu rity inv estm ents , each of w hich has no
reference to any other part of the cu rv e.
For ex am ple, bank s and bu ilding societies concentrate a large part of
their activ ity at the short end of the cu rv e, as part of daily cash
m anagem ent (k now n as asset and liability management) and for
regu latory pu rposes (k now n as liquidity requ irem ents). How ev er,
fu nd m anagers su ch as pension fu nds and insu rance com panies
are activ e at the long end of the m ark et. Bu t, few institu tional
inv estors hav e any preference for m ediu m -dated bonds . This behav -
iou r on the part of inv estors w ill lead to high prices (low y ields ) at
both the short and long ends of the y ield cu rv e and low er prices
(higher y ields) in the m iddle of the term stru ctu re.
According to the segm ented m ark ets hy pothesis a separate m ark et
ex ists for specifi c m atu rities along the term stru ctu re, hence interest
rates for these m atu rities are set by su pply and dem and. 4 Where there
is no dem and for a particu lar m atu rity , the y ield w ill lie abov e other
segm ents. Mark et participants do not hold bonds in any other area of
the cu rv e ou tside their area of interest 5 so that short-dated and long-
dated bond y ields ex ist independently of each other. The segm ented
m ark ets theory is u su ally illu strated by reference to bank s and life
assu rance com panies. Bank s and bu ilding societies u su ally hold
See Cu lbertson (1957).

For ex am ple, retail and com m ercial bank s hold bonds for short dates,
w hile life assu rance com panies hold long-dated bonds.
THE YIELD CURVE 79
their fu nds in short-dated instru m ents for no longer than 5 y ears in

m atu rity . This is becau se of the natu re of retail bank ing operations,
w ith a large v olu m e of instant access fu nds being deposited at bank s,
and also for regu latory pu rposes. Holding short-term , liqu id bonds
enables bank s to m eet any su dden or u nex pected dem and for fu nds
from cu stom ers. The classic theory su ggests that – as bank s inv est
their fu nds in short-dated bonds – the y ields on these bonds are
driv en dow n. When they then liqu idate part of their holding,
perhaps to m eet higher dem and for loans, the y ields are driv en u p
and the prices of the bonds fall. This affects the short end of the y ield
cu rv e bu t not the long end.
The segm ented m ark ets theory can be u sed to ex plain any particu lar
shape of the y ield cu rv e, althou gh it perhaps fi ts best w ith positiv e-
sloping cu rv es. How ev er, it cannot be u sed to interpret the y ield
cu rv e w hatev er shape it m ay be, and therefore offers no inform ation
content du ring analy sis. By defi nition, the theory su ggests that – for
inv estors – bonds w ith different m atu rities are not perfect su bsti-
tu tes for each other. This is becau se different bonds w ou ld hav e
different holding period retu rns, m ak ing them im perfect su bstitu tes
for one another. 6 As a resu lt of bonds being im perfect su bstitu tes,
m ark ets are segm ented according to m atu rity .
The segm entations hy pothesis is a reasonable ex planation of certain

featu res of a conv entional positiv e-sloping y ield cu rv e, bu t by itself is
not su ffi cient. There is no dou bt that bank s and bu ilding societies
hav e a requ irem ent to hold secu rities at the short end of the y ield
cu rv e, as m u ch for regu latory pu rposes as for y ield considerations ;
how ev er, other inv estors are probably m ore fl ex ible and w ill place
fu nds w here v alu e is deem ed to ex ist. Nev ertheless , the higher
dem and for benchm ark secu rities does driv e dow n y ields along
certain segm ents of the cu rv e.
A slightly m odifi ed v ersion of the m ark et segm entation hy pothesis

is k now n as the preferred habitat theory. This su ggests that different
m ark et participants hav e an interest in specifi ed areas of the y ield
cu rv e, bu t can be indu ced to hold bonds from other parts of the
m atu rity spectru m if there is su ffi cient incentiv e. Hence, bank s
m ay at certain tim es hold longer dated bonds once the price of
these bonds falls to a certain lev el, m ak ing the retu rn on the
bonds w orth the risk inv olv ed in holding. Sim ilar considerations
Ibid.
m ay persu ade long-term inv estors to hold short-dated debt. So,

higher y ields w ill be requ ired to m ak e bondholders shift ou t of
their u su al area of interest. This theory essentially recognizes
the fl ex ibility that inv estors hav e – ou tside regu latory or legal
constraints (su ch as the term s of an institu tional fu nd’s
objectiv es) – to inv est in w hatev er area of the y ield cu rv e they
identify v alu e.
The flat yield curve

Conv entional theories do not seek to ex plain a fl at y ield cu rv e.
Althou gh it is rare – certainly for any length of tim e – to observ e
fl at cu rv es in a m ark et, at tim es they do em erge in response to
pecu liar econom ic circu m stances . In conv entional think ing, a fl at
cu rv e is not tenable becau se inv estors shou ld in theory hav e no
incentiv e to hold long-dated bonds ov er shorter dated bonds w hen
there is no y ield prem iu m , so that the y ield at the long end shou ld
rise as they sell off long-dated paper, produ cing an u pw ard-sloping
cu rv e. In prev iou s occu rrences of a fl at cu rv e, analy sts hav e produ ced
different ex planations for their ex istence. In Nov em ber 1988 the US
Treasu ry y ield cu rv e w as fl at relativ e to the recent past; researchers
contended that this w as the resu lt of the m ark et’s v iew that long-
dated y ields w ou ld fall as bond prices rallied u pw ards . 7 One recom -
m endation is to bu y longer m atu rities w hen the y ield cu rv e is fl at, in
anticipation of low er long-term interest rates, w hich is diam etrically
opposite to the v iew that a fl at cu rv e is a signal to sell long bonds. In
the case of the US m ark et in 1988, long bond y ields did in fact fall by
approx im ately 2% in the follow ing 12 m onths. This w ou ld seem to
indicate that one’s v iew of fu tu re long-term rates shou ld be behind
the decision to bu y or sell long bonds , rather than the shape of the
y ield cu rv e itself. A fl at cu rv e m ay w ell be m ore heav ily infl u enced
by su pply and dem and factors than any thing else, w ith the m ajority
opinion ev entu ally w inning ou t and forcing the cu rv e to change into
a m ore conv entional shape.
Further views on the yield curve

In this discu s sion w e hav e assu m ed the econom is t’s w orld of a
perfect market (also som etim es called a frictionless fi nancial
m ark et). Su ch a perfect capital m ark et is characterized by
See Lev y (1999).

THE YIELD CURVE 81
perfect inform ation;

no tax es;
bu llet m atu rity bonds ;
no transaction costs.
Of cou rse, m ark ets are not perfect in practice. How ev er, assu m ing
perfect m ark ets m ak es the discu ssion of the term stru ctu re easier to
handle. When w e analy se y ield cu rv es for their inform ation content,
w e hav e to rem em ber that the m ark ets that they represent are not
perfect, and that frequ ently w e observ e anom alies that cannot be
ex plained by conv entional theories.
At any one tim e it is probably m ore realistic to su ggest that a range of

factors contribu te to the y ield cu rv e being a particu lar shape. For
instance, short-term interest rates are greatly infl u enced by the
av ailability of fu nds in the m oney m ark et. The slope of the y ield
cu rv e (u su ally defi ned as 10-y ear y ield m inu s 3-m onth interest rate)
is also a m easu re of the degree of tightness of gov ernm ent m onetary
policy . A low , u pw ard-sloping cu rv e is often thou ght to be a sign that
an env ironm ent of cheap m oney , du e to looser m onetary policy , is to
be follow ed by a period of higher infl ation and higher bond y ields .
Equ ally , a high dow nw ard-sloping cu rv e is tak en to m ean that a
situ ation of tight credit, du e to stricter m onetary policy , w ill
resu lt in falling infl ation and low er bond y ields . Inv erted y ield
cu rv es hav e often preceded recessions; for instance, an article in
The Economist in April 1998 rem ark ed that in the United States
ev ery recess ion since 1955 bar one has been preceded by a negativ e
y ield cu rv e. The analy sis is the sam e: if inv estors ex pect a recess ion
they also ex pect infl ation to fall, so the y ields on long-term bonds
w ill fall relativ e to short-term bonds . So, the conv entional ex plana-
tion of an inv erted y ield cu rv e is that the m ark ets and the inv estm ent
com m u nity ex pect either a slow dow n of the econom y – if not an
ou tright recess ion.8 In this case one w ou ld ex pect m onetary policy to
ease the m oney su pply by redu cing the base interest rate in the near
fu tu re: hence, an inv erted cu rv e. At the sam e tim e, a redu ction in
short-term interest rates w ill affect short-dated bonds , w hich are
then sold off by inv estors, fu rther raising their y ield.
While the conv entional ex planation for negativ e y ield cu rv es is

ex pectation of econom ic slow dow n, on occasion other factors are
A recession is form ally defi ned as tw o su ccessiv e qu arters of falling ou tpu t

in the dom estic econom y .
inv olv ed. In the UK betw een Ju ly 1997 and Ju ne 1999 the gilt y ield
cu rv e w as inv erted. How ev er, there w as no general v iew that the
econom y w as heading for recess ion; in fact, the new Labou r gov ern-
m ent (or shou ld that be New Labou r?) inherited an econom y believ ed
to be in good health. Instead, the ex planation behind the inv erted
shape of the gilt y ield cu rv e focu sed on tw o other factors: fi rst, the
handing of responsibility for setting interest rates to the Monetary
Policy Com m ittee (MPC) of the Bank of England and, second, the
ex pectation that the UK w ou ld abandon sterling ov er the m ediu m
term and adopt the eu ro. The y ield cu rv e at this tim e su ggested that
the m ark et ex pected the MPC to be su ccess fu l and k eep infl ation at a
lev el arou nd 2.5% ov er the long term (its target is actu ally the 1%
range either side of 2.5% ); it also su ggested that sterling interest
rates w ou ld need to com e dow n ov er the m ediu m term as part of
convergence w ith conditions in Eu rope’s eu ro cu rrency area.
How ev er, these w ere both m ediu m -term ex pectations and in the
au thor’s v iew not tenable at the short end of the y ield cu rv e. In
fact, the term stru ctu re m ov ed to a positiv e-sloped shape u p to
the 6-to-7-y ear area, before inv erting ou t to the long end of the
cu rv e, in Ju ne 1999. By the beginning of 2002 it had assu m ed a
conv entional positiv e-sloping shape. This is a m ore logical shape
for the cu rv e to assu m e.
There is therefore signifi cant inform ation content in the y ield cu rv e,

and econom ists and bond analy sts w ill consider the shape of the
cu rv e as part of their policy -m ak ing and inv estm ent adv ice. The
shape of parts of the cu rv e, w hether the short end or long end, as
w ell as that of the entire cu rv e, can serv e as u sefu l predictors of
fu tu re m ark et conditions. As part of an analy sis it is also w orthw hile
considering y ield cu rv es across sev eral different m ark ets and cu r-
rencies. For instance, the interest rate sw ap cu rv e, and its position
relativ e to that of the gov ernm ent bond y ield cu rv e, is also regu larly
analy sed for its inform ation content. In dev eloped cou ntry
econom ies the interest rate sw ap m ark et is inv ariably as liqu id as
the gov ernm ent bond m ark et – if not m ore so – hence, it is com m on
to see the sw ap cu rv e analy sed w hen m ak ing predictions abou t, say ,
the fu tu re lev el of short-term interest rates.9
Interest rate sw aps are deriv ativ e instru m ents u sed in professional
w holesale m ark ets to change the basis of an interest rate liability ; they
are also u sed for specu lativ e trading pu rposes. We don’t need to w orry abou t
them .
THE YIELD CURVE 83
Gov ernm ent policy w ill infl u ence the shape and lev el of the y ield
cu rv e, inclu ding its policy on pu blic sector borrow ing, debt m anage-
m ent and open-m ark et operations. The m ark et’s perception of the
size of pu blic sector debt w ill infl u ence bond y ields – for instance, an
increase in the lev el of debt can lead to an increase in bond y ields
across the m atu rity range. Open-m ark et operations – that is, the
Bank of England’s daily operations to control the m oney su pply
(to w hich end the Bank pu rchases short-term bills and also
engages in repo dealing) – can hav e a nu m ber of effects. In the
short term they can tilt the y ield cu rv e both u pw ards and dow n-
w ards ; in the longer term , changes in the lev el of the base rate w ill
affect y ield lev els. An anticipated rise in base rates can lead to a drop
in prices for short-term bonds , w hose y ields w ill be ex pected to rise;
this can lead to a tem porary inv erted cu rv e. Finally , debt m anage-
m ent policy w ill infl u enc e the y ield cu rv e. Mu ch gov ernm ent debt is
rolled ov er as it m atu res, bu t the m atu rity of the replacem ent debt
can hav e a signifi cant infl u ence on the y ield cu rv e in the form of
hu m ps in the m ark et segm ent in w hich the debt is placed, as long as
the debt is priced by the m ark et at a relativ ely low price and hence
high y ield.
The zero-coupon y ield curve

The zero-coupon (or spot) yield curve plots zero-cou pon y ields (or
spot y ields) against the term to m atu rity . A zero-cou pon y ield is the
y ield prev ailing on a bond that has no cou pons. In the fi rst instance –
as long as there is a liqu id zero-cou pon bond m ark et – w e can plot the
y ields from these bonds if w e w ish to constru ct this cu rv e. How ev er,
it is not necessary to hav e a set of zero-cou pon bonds in order to
constru ct this cu rv e, as w e can deriv e it from a cou pon or par y ield
cu rv e; in fact, in m any m ark ets w here zero-cou pon bonds are not
traded, a spot y ield cu rv e is deriv ed from the conv entional-y ield-to-
m atu rity -y ield cu rv e. This is of cou rse a theoretical zero-cou pon
(spot) y ield cu rv e, as opposed to a market or observed spot cu rv e
that can be constru cted u sing the y ields of actu al zero-cou pon bonds
trading in the m ark et.
Spot y ields m u st com ply w ith equ ation (3.1). This equ ation assu m es
annu al cou pon pay m ents and that the calcu lation is carried ou t on a
cou pon date su ch that accru ed interest is zero:

N
C M
Pd
n 1
1 rsn n 1 rsT N
N
C D fn M D fN 31
n 1
w here
rsn Spot or zero-cou pon y ield on a bond w ith t y ears to
m atu rity ;
D fn 1 1 rsn n Corresponding discount factor.
In equ ation (3.1), rs1 is the cu rrent 1-y ear spot y ield, rs2 the cu rrent
2-y ear spot y ield and so on. Theoretically , the spot y ield for a par-
ticu lar term to m atu rity is the sam e as the y ield on a zero-cou pon
bond of the sam e m atu rity , w hich is w hy spot y ields are also k now n
as zero-cou pon y ields .
This last resu lt is im portant. It m eans spot y ields can be deriv ed from
redem ption y ields that hav e been observ ed in the m ark et.
As w ith the y ield-to-redem ption y ield cu rv e the spot y ield cu rv e is
com m only u sed in the m ark et. It is v iew ed as the tru e term stru ctu re
of interest rates becau se there is no reinv es tm ent risk inv olv ed; the
stated y ield is equ al to actu al annu al retu rn. That is, the y ield on a
zero-cou pon bond of n y ears m atu rity is regarded as the tru e n-y ear
interest rate. Becau se the observ ed gov ernm ent bond redem ption
y ield cu rv e is not considered to be the tru e interest rate, analy sts
often constru ct a theoretical spot y ield cu rv e. Essentially , this is
done by break ing dow n each cou pon bond being observ ed into its
constitu ent cashfl ow s, w hich becom e a series of indiv idu al zero-
cou pon bonds . For ex am ple, £100 nom inal of a 5% 2-y ear bond
(pay ing annu al cou pons) is considered equ iv alent to £5 nom inal of
a 1-y ear zero-cou pon bond and £105 nom inal of a 2-y ear zero-cou pon
bond.
Let u s assu m e that there are 30 bonds in the m ark et all pay ing annu al
cou pons. The fi rst bond has a m atu rity of 1 y ear, the second bond of
2 y ears, and so on ou t to 30 y ears. We k now the price of each of these
bonds , bu t w e w is h to determ ine w hat the prices im ply abou t the
m ark et’s estim ate of fu tu re interest rates. We natu rally ex pect inter-
est rates to v ary ov er tim e and that all pay m ents being m ade on the
sam e date are v alu ed u sing the sam e rate. For the 1-y ear bond w e
THE YIELD CURVE 85
k now its cu rrent price and the am ou nt of the pay m ent (com prising
one cou pon pay m ent and the redem ption proceeds) w e w ill receiv e at
the end of the y ear; therefore, w e can calcu late the interest rate for
the fi rst y ear. Assu m e the 1-y ear bond has a cou pon of 5% . If the bond
is priced at par and w e inv est £100 today w e w ill receiv e £105 in one
y ear’s tim e, hence the rate of interest is apparent and is 5% . For the
2-y ear bond w e u se this interest rate to calcu late the fu tu re v alu e of
its cu rrent price in 1 y ear’s tim e: this is how much we would receive
if we had invested the same amount in the 1-year bond. How ev er,
the 2-y ear bond pay s a cou pon at the end of the fi rst y ear; if w e
su btract this am ou nt from the fu tu re v alu e of the cu rrent price,
the net am ou nt is w hat w e shou ld be giv ing u p in 1 y ear in
retu rn for the one rem aining pay m ent. From these nu m bers w e
can calcu late the interest rate in Year 2.
Ass u m e that the 2-y ear bond pay s a cou pon of 6% and is priced at
99.00. If 99.00 w as inv ested at the rate w e calcu lated for the 1-y ear
bond (5% ), it w ou ld accu m u late £103.95 in 1 y ear, m ade u p of the
£99 inv estm ent and interest of £4.95. On the pay m ent date in 1 y ear’s
tim e, the 1-y ear bond m atu res and the 2-y ear bond pay s a cou pon of
6% . If ev ery one ex pected the 2-y ear bond at this tim e to be priced at
m ore than 97.95 (w hich is 103.95 m inu s 6.00), then no inv estor
w ou ld bu y the 1-y ear bond, since it w ou ld be m ore adv antageou s
to bu y the 2-y ear bond and sell it after 1 y ear for a greater retu rn.
Sim ilarly , if the price w as less than 97.95 no inv estor w ou ld bu y the
2-y ear bond, as it w ou ld be cheaper to bu y the shorter bond and then
bu y the longer dated bond w ith the proceeds receiv ed w hen the
1-y ear bond m atu res. Therefore, the 2-y ear bond m u st be priced at
ex actly 97.95 in 12 m onths’ tim e. For this £97.95 to grow to £106.00
(the m atu rity proceeds from the 2-y ear bond, com prising the redem p-
tion pay m ent and cou pon interest), the interest rate in Year 2 m u st
be 8.20% . We can check this u sing the present v alu e form u la cov ered
earlier. At these tw o interest rates, the tw o bonds are said to be in
equ ilibriu m .
This is an im portant resu lt and show s that there can be no arbitrage

opportu nity along the y ield cu rv e; u sing interest rates av ailable
today the retu rn from bu y ing the 2-y ear bond m u st equ al the
retu rn from bu y ing the one-y ear bond and rolling ov er the proceeds
(or reinvesting) for another y ear. This is the k now n as the breakeven
principle.
Using the price and cou pon of the 3-y ear bond w e can calcu late the
interest rate in Year 3 in precisely the sam e w ay . Using each of the
bonds in tu rn, w e can link together the implied 1-year rates for each
y ear u p to the m atu rity of the longest dated bond. The process is
k now n as boot-strapping. The ‘av erage’ rate ov er a giv en period is the
spot y ield for that term : in the ex am ple giv en abov e, the rate in Year 1
is 5% , and in Year 2 is 8.20% . An inv estm ent of £100 at these rates
w ou ld grow to £113.61. This giv es a total percentage increase of
13.61% ov er 2 y ears, or 6.588% per annu m . The av erage rate is
not obtained by sim ply div iding 13.61 by 2, bu t – u sing ou r
present v alu e relationship again – by calcu lating the squ are root
of ‘1 plu s the interest rate’ and then su btracting 1 from this
nu m ber. Thu s, the 1-y ear y ield is 5% and the 2-y ear y ield is 8.20% .
In real-w orld m ark ets it is not necessarily as straightforw ard as this;
for instance, on som e dates there m ay be sev eral bonds m atu ring,
w ith different cou pons, and on som e dates there m ay be no bonds
m atu ring. It is m ost u nlik ely that there w ill be a regu lar spacing of
bond redem ptions ex actly 1 y ear apart. For this reason it is com m on
for analy sts to u se a softw are m odel to calcu late the set of im plied
spot rates w hich best fi ts the m ark et prices of the bonds that do ex ist
in the m ark et. For instance, if there are sev eral 1-y ear bonds, each of
their prices m ay im ply a slightly different rate of interest. We choose
the rate w hich giv es the sm alles t av erage price error. In practice, all
bonds are u sed to fi nd the rate in Year 1, all bonds w ith a term longer
than 1 y ear are u sed to calcu late the rate in Year 2, and so on. The
zero-cou pon cu rv e can also be calcu lated directly from the cou pon
y ield cu rv e u sing a m ethod sim ilar to that described abov e; in this
case, the bonds w ou ld be priced at par and their cou pons set to par
y ield v alu es.
The zero-cou pon y ield cu rv e is ideal to u se w hen deriv ing im plied
forw ard rates, w hich w e consider nex t, and w hen defi ning the term
stru ctu re of interest rates. It is also the best cu rv e to u se w hen
determ ining the relative value, w hether cheap or dear, of bonds
trading in the m ark et, and w hen pricing new issu es, irrespectiv e
of their cou pons.
Arithmetic
Hav ing introdu ced the concept of the zero-cou pon cu rv e in the
prev iou s section, w e can illu strate the m athem atics inv olv ed
m ore form ally . When deriv ing spot y ields from redem ption y ields ,
w e v iew conv entional bonds as being m ade u p of an annuity (the
stream of fi x ed cou pon pay m ents ) and a zero-cou pon bond (the
THE YIELD CURVE 87
redem ption pay m ent on m atu rity ). To deriv e the rates w e can u se
equ ation (3.1), setting P d M 100 and C rmN , as show n in
equ ation (3.2). This has cou pon bonds trading at par, so that the
cou pon is equ al to the y ield:
N
100 rmN D fn 100 DN
n 1
rmN AN 100 DN 32
w here rmN is par y ield for a term to m atu rity of N y ears, the discou nt
factor D fN is the fair price of a zero-cou pon bond w ith a par v alu e of
£1 and a term to m atu rity of N y ears, and
N
AN D fn AN 1 D fN 33
n 1
is the fair price of an annu ity of £1 per y ear for N y ears (w ith A 0 0
by conv ention). Su bs titu ting equ ation (3.3) into equ ation (3.2) and
re-arranging w ill giv e u s the ex pression for the N -y ear discou nt
factor show n in equ ation (3.4):
1 rmN A N 1
D fN 34
1 rmN
If w e assu m e 1-y ear, 2-y ear and 3-y ear redem ption y ields for bonds
priced at par to be 5% , 5.25% and 5.75% , respectiv ely , w e w ill obtain
the follow ing solu tions for the discou nt factors:
1
D f1 0 95238
1 0 05
1 0 0525 0 95238
D f2 0 90261
1 0 0525
1 0 0575 0 95238 0 90261
D f3 0 84476
1 0 0575
We can confi rm that these are the correct discou nt factors by
su bstitu ting them back into equ ation (3.2); this giv es u s the follow -
ing resu lts for the 1-y ear, 2-y ear and 3-y ear par v alu e bonds (w ith
cou pons of 5% , 5.25% and 5.75% , respectiv ely ):
100 105 0 95238
100 5 25 0 95238 105 25 0 90261
100 5 75 0 95238 5 75 0 90261 105 75 0 84476
Now that w e hav e fou nd the correct discou nt factors it is relativ ely
straightforw ard to calcu late the spot y ields u sing equ ation (3.1):
1
D f1 0 95238 w hich giv es rs1 5 0%
1 rs1
1
D f2 0 90261 w hich giv es rs2 5 269%
1 rs2 2
1
D f3 0 84476 w hich giv es rs3 5 778%
1 rs3 3
Equ ation (3.1) discou nts the n-y ear cashfl ow (com prising the cou pon
pay m ent and/or principal repay m ent) by the corresponding n-y ear
spot y ield. In other w ords rsn is the time-weighted rate of return on a
n-y ear bond. Thu s, as w e said in the prev iou s section the spot y ield
cu rv e is the correct m ethod for pricing or v alu ing any cashfl ow ,
inclu ding an irregu lar cashfl ow , becau se it u ses the appropriate
discou nt factors. That is, it m atches each cashfl ow to the discou nt
rate that applies to the tim e period in w hich the cashfl ow is paid.
Com pare this w ith the approach for calcu lating the y ield-to-m atu r-
ity , w hich discou nts all cashfl ow s by the sam e y ield to m atu rity .
This neatly illu strates w hy the n-period zero-cou pon interest rate is
the tru e interest rate for an N -y ear bond.
The ex pressions abov e are solv ed algebraically in the conv entional
m anner, althou gh those w is hing to u se a spreadsheet application
su ch as Microsoft Ex cel can inpu t the constitu ents of each equ a-
tion into indiv idu al cells and solv e u s ing the ‘Tools’ and ‘Goal Seek ’
fu nctions.
There is a v ery large literatu re on the zero-cou pon y ield cu rv e.
A sm all fraction of it – as referred to in this chapter – is giv en in
the Bibliography at the end of the chapter.
Ex am ple calculation illustrations

In this section w e illu strate som e elem entary u ses of the y ield cu rv e
by prov iding som e ex am ple calcu lations .
Forward rates: Breakeven principle

Consider the follow ing spot y ields :
1-y ear 10%
2-y ear 12%
THE YIELD CURVE 89
Ass u m e that a bank ’s client w ishes to lock in today the cost of

borrow ing 1-y ear fu nds in 1 y ear’s tim e. The solu tion for the bank
(and the m echanism to enable the bank to qu ote a price to the client)
inv olv es raising 1-y ear fu nds at 10% and inv esting the proceeds for
2 y ears at 12% . The no-arbitrage principle m eans that the sam e
retu rn m u st be generated from both fi x ed rate and reinv es tm ent
strategies.
In effect, w e can look at the issu e in term s of tw o alternativ e
inv estm ent strategies, both of w hich m u st prov ide the sam e retu rn:
Strategy 1 Inv est fu nds for 2 y ears at 12% .
Strategy 2 Inv est fu nds for 1 y ear at 10% , and reinv est the
proceeds for a fu rther y ear at the forw ard rate
calcu lated today .
The forw ard rate for Strategy 2 is the rate that w ill be qu oted to the
client. Using the present v alu e relationship w e k now that the
proceeds from Strategy 1 are:
2
FV 1 r2
w hile the proceeds from Strategy 2 w ou ld be:

FV 1 r1 1 R
We k now from the no-arbitrage principle that the proceeds from both
strategies w ill be the sam e, therefore this enables u s to set:
2
1 r2 1 r1 1 R
1 r2 2
R 1
1 r1
This enables u s to calcu late the forw ard rate that can be qu oted to
the client (together w ith any spread that the bank m ight add) as
follow s:
2
1 0 12 1 0 10 1 R
2
1 R 1 0 12 1 0 10
1 R 1 14036
R 14 04%
This rate is the 1-y ear forw ard–forw ard rate, or the im plied forw ard
rate.
Further examples
If a 1-y ear AAA Eu robond trading at par y ields 10% and a 2-y ear
Eu robond of sim ilar credit qu ality , also trading at par, y ields 8.75% ,
w hat shou ld the price of a 2-y ear AAA zero-cou pon bond be?
Note that Eu robonds pay cou pon annu ally :
(a) Cost of 2-y ear bond
(per cent nom inal) 100
(b) less am ou nt receiv able from
sale of fi rst cou pon on this
bond (i.e., its present v alu e) 8 75 1 0 10
7 95
(c) equals am ou nt that m u st be
receiv ed on sale of second
cou pon plu s principal in order
to break ev en 92.05
(d) calcu late the y ield im plied in
the cashfl ow s below (i.e., the
2-y ear zero-cou pon y ield)
– receiv e 92.05
– pay ou t on m atu rity 108.75
2
Therefore 92 05 108 75 1 R
Giv es R equ al to 8.69%
(e) What is the price of a 2-y ear
zero-cou pon bond w ith nom inal
v alu e 100, to y ield 8.69% ? 92 05 108 75 100
84.64
A highly -rated cu stom er ask s y ou to fi x a y ield at w hich he cou ld
issu e a 2-y ear zero-cou pon USD Eu robond in 3 y ears’ tim e. At this
tim e the US Treasu ry zero-cou pon rates w ere:
1 y ear 6.25%
2 y ear 6.75%
3 y ear 7.00%
4 y ear 7.125%
5 y ear 7.25%
(a) Ignoring borrow ing spreads ov er these benchm ark y ields, as a
m ark et-m ak er y ou cou ld cov er the ex posu re created by borrow -
ing fu nds for 5 y ears on a zero-cou pon basis and placing these
fu nds in the m ark et for 3 y ears before lending them on to y ou r
THE YIELD CURVE 91
client. Assu m e annu al interest com pou nding (ev en if none is

actu ally paid ou t du ring the life of the loans):
R5
Borrow ing rate for 5 y ears 0 0725
100
R3
Lending rate for 3 y ears 0 0700
100
(b) The k ey arbitrage relationship is:
Total cost of fu nding Total retu rn on inv estm ents
5 3 2
1 R5 1 R3 1 R3 5
Therefore, break ev en forw ard y ield is :

5
2 1 0 0725
1 R3 5
1 0 0700 3
1 0 0725 5
1 R3 5
1 0 0700 3
1 0 0725 5
R3 5 1
1 0 0700 3
7 63%
FORWARD RATE CALCULATION FOR

MONEY MARKET TERM
Consider tw o positions:
Borrow ing £100 m illion today for 30 day s at 5.875%
Lending £100 m illion today for 60 day s at 6.125%
The tw o positions can be v iew ed as a 30-day forw ard 30-day interest
rate ex posu re (a 30-day v ersu s 60-day forw ard rate). It is u su ally
referred to as an interest rate gap position. What forw ard rate
m u st be u sed if the trader w ished to hedge this ex posu re?
The 30-day by 60-day forw ard rate can be calcu lated u sing the
follow ing form u la:
nL
1 rsL % B
rfi B 1 35
nS n nS
1 rsS % L
B
w here
rfi Forw ard rate;
rsL % Long-period rate;
rsS % Short-period rate;
nL Long-period term in day s;
nS Short-period term in day s;
B Day -cou nt base, either 360 or 365 (in this case 365).
Using this form u la w e obtain a 30-day v ersu s 60-day forw ard rate of
6.3443% .
This interest rate ex posu re can be hedged u sing interest rate fu tu res
or forw ard rate agreem ents (FRAs). Either m ethod is an effectiv e
hedging m echanism , althou gh the trader m u st be aw are of
the basis risk that ex ists betw een cash m ark et rates and the
forw ard rates im plied by fu tu res and FRAs;
date m is m atches betw een ex piry of fu tu res contracts and the
m atu rity dates of cash m ark et transactions .
Understanding forw ard rates

Spot and forw ard rates calcu lated from cu rrent m ark et rates follow
m athem atical principles to establish w hat the arbitrage-free rates for
dealing today w ill be at som e point in the fu tu re. In other w ords,
forw ard rates and spot rates are actu ally say ing the sam e thing.
How ev er, as w e hav e already noted, forw ard rates are not a prediction
of fu tu re rates. It is im portant to be aw are of this distinction. If w e
w ere to plot the forw ard rate cu rv e for the term stru ctu re in 3
m onths’ tim e, and then com pare it in 3 m onths w ith the actu al
term stru ctu re prev ailing at the tim e, the cu rv es w ou ld certainly
not m atch. How ev er, this has no bearing on ou r earlier statem ent:
that forw ard rates are the m athem atical expectation of fu tu re rates.
The m ain point to bear in m ind is that w e are not com paring lik e for
lik e w hen plotting forw ard rates against actu al cu rrent rates at a
fu tu re date. When w e calcu late forw ard rates, w e u se the cu rrent
term stru ctu re. The cu rrent term stru ctu re incorporates all k now n
inform ation, both econom ic and political, and refl ects the m ark et’s
v iew s. This is ex actly the sam e as w hen w e say that a com pany ’s
share price refl ects all that is k now n abou t the com pany and all that
is ex pected to happen w ith regard to the com pany in the near fu tu re,
inclu ding ex pected fu tu re earnings. The term stru ctu re of interest
THE YIELD CURVE 93
rates refl ects ev ery thing the m ark et k now s abou t relev ant dom estic
and international factors. It is this inform ation, then, that goes into
forw ard rate calcu lation. An instant later, thou gh, there w ill be new
dev elopm ents that w ill alter the m ark et’s v iew and therefore alter
the cu rrent term stru ctu re; these dev elopm ents and ev ents w ere (by
defi nition, as w e cannot k now w hat lies in the fu tu re!) not k now n at
the tim e w e calcu lated and u sed 3-m onth forw ard rates. This is w hy
rates actu ally tu rn ou t to be different from w hat the term stru ctu re
m athem atically constru cted at an earlier date. How ev er, for dealing
today w e u se today ’s forw ard rates, w hich refl ect ev ery thing w e
k now abou t the m ark et today .
BIBLIOGRAPHY
Cam pbell, J. (1986) ‘A defence of traditional hy potheses abou t the term
stru ctu re of interest rates,’ Journal of Finance, March, 183–193.
Chou dhry , M. (1998) ‘The inform ation content of the United Kingdom
gilt y ield cu rv e,’ u npu blished MBA assignm ent, Henley Managem ent
College.
Chou dhry , M. (2001) The Bond and Money Markets, Bu tterw orth
Heinem ann, Chapters 51–53.
Chou dhry , M. (2009) ‘The v alu e of introdu cing stru ctu ral reform to
im prov e bond m ark et liqu idity : Ex perience from the U.K. gilt m ark et,’
European Journal of Finance and Banking Research, 2(2).
Cox , J., Ingersoll, J.E., and Ross, S.A. (1981) ‘A re-ex am ination of traditional
hy potheses abou t the term stru ctu re of interest rates,’ Journal of Finance,
36, Septem ber, 769–799.
Cu lbertson, J.M. (1957) ‘The term stru ctu re of interest rates,’ Q uarterly
Journal of Economics, 71, Nov em ber, 485–517.
The Economist (1998) ‘Adm iring those shapely cu rv es,’ 4 April, p.117.
Fam a, E.F. (1976) ‘Forw ard rates as predictors of fu tu re spot interest rates,’
Journal of Financial Economics, 3(4), October, 361–377.
Fam a, E.F. (1984) ‘The inform ation in the term stru ctu re,’ Journal of
Financial Economics, 13, Decem ber, 509–528.
Fisher, I. (1986) ‘Appreciation of interest,’ Publications of the American
Economic Association, Au gu st, 23–39.
Hick s, J. (1946) Value and C apital, Ox ford Univ ersity Press, 1946.
Ingersoll, J. (1987) Theory of Financial D ecision Making, Row m an &
Littlefi eld, Chapter 18.
Jarrow , R. (1996) Modelling Fixed Income Securities and Interest Rate
O ptions, McGraw -Hill.
Lev y , H. (1999) Introduction to Investments, Second Edition, Sou th-
Western.
Liv ingstone, M. (1990) Money and C apital Markets, Prentice Hall.
Lu tz, F. (1940) ‘The stru ctu re of interest rates,’ Q uarterly Journal of

Economics, Nov em ber, 36–63.
McCu lloch, J.H. (1975) ‘An estim ate of the liqu idity prem iu m ,’ Journal of
Political Economy, 83, Janu ary /Febru ary , 95–119.
Meiselm an, D. (1962) The Term Structure of Interest Rates, Prentice Hall.
Ru binstein, M. (1999) Rubinstein on D erivatives, RISK Pu blishing.
By Moorad Choudhry
Chapter
4
INTRODUCTION TO
TRADING AND
HEDGING
I n this chapter w e introdu ce the basics of trading and hedging as

em ploy ed by a bank asset–liability m anagem ent (ALM) desk . The
instru m ents and techniqu es u sed form the fu ndam ental bu ilding
block s of ALM, so the reader can im agine that a fu ll and com pre-
hensiv e treatm ent of this su bject w ou ld requ ire a book in its ow n
right. 1 Ou r pu rpose here is to acqu aint the new com er to the m ark et
w ith the essentials , w ith fu rther recom m ended reading su ggested in
the Bibliography .
The ALM and m oney m ark et desk has a v ital fu nction in a bank ,
fu nding all the bu s iness lines in the bank . In som e bank s and secu r-
ities hou ses it w ill be placed w ithin the Treasu ry or m oney m ark et
areas, w hereas other fi rm s w ill organize it as an entirely separate
fu nction. Wherev er it is organized, the need for clear and constant
com m u nication betw een the ALM desk and the other operating
areas of the bank is param ou nt. We present an ov erv iew of ALM,
liqu idity and interest rate strategy in the nex t chapter; here w e look
at specifi c u ses of m oney m ark et produ cts lik e deposits and repo in
the contex t of y ield enhancem ent and m ark et-m ak ing.
TRADING APPROACH
The y ield curve and interest rate ex pectations
When the y ield cu rv e is positiv ely sloped, the conv entional approach
is to fu nd the book at the short end of the cu rv e and lend at the long
end. In essence, therefore, if the y ield cu rv e resem bled that show n
in Figu re 4.1 a bank w ou ld borrow , say , 1-w eek fu nds w hile sim u l-
taneou sly lending ou t at, say , 3-m onth m atu rity . This is k now n as
funding short. A bank can effect the econom ic equ iv alent of borrow -
ing at the short end of the y ield cu rv e and lending at the longer end
throu gh repo transactions – in ou r ex am ple, a 1-w eek repo and a
3-m onth rev erse repo. The bank then continu ou sly rolls ov er its
fu nding at 1-w eek interv als for the 3-m onth period. This is also
k now n as creating a tail; here the ‘tail’ is the gap betw een 1 w eek
and 3 m onths – the interest rate ‘gap’ that the bank is ex posed to.
Du ring the cou rse of the trade – as the rev erse repo has lock ed in a
loan for 6 m onths – the bank is ex posed to interest rate risk shou ld
See Chou dhry (2007).

INTRODUCTION TO TRADING AND HEDGING 97
Figure 4.1 Positiv e y ield cu rv e fu nding.
the slope or shape of the y ield cu rv e change. In this case the bank
m ay see its profi t m argin shrink or tu rn into a fu nding loss if short-
dated interest rates rise.
As w e noted in Chapter 3, a nu m ber of hy potheses hav e been

adv anced to ex plain the shape of the y ield cu rv e at any particu lar
tim e. A steep positiv e-shaped cu rv e m ay indicate that the m ark et
ex pects interest rates to rise ov er the longer term , althou gh this is
also som etim es giv en as the reason for an inv erted cu rv e w ith regard
to shorter term rates. Generally speak ing, trading v olu m es are higher
in a positiv e-sloping y ield cu rv e env ironm ent, com pared w ith a fl at
or negativ e-shaped cu rv e.
In the case of an inv erted y ield cu rv e, a bank w ill (all else being equ al)
lend at the short end of the cu rv e and borrow at the longer end. This
is k now n as funding long and is show n in Figu re 4.2.
The ex am ple in Figu re 4.2 show s a short cash position of 2-w eek
m atu rity against a long cash position of 4-m onth m atu rity . The
interest rate gap of 10 w eek s is the book ’ s interest rate ex posu re.
The inv erted shape of the y ield cu rv e m ay indicate m ark et ex pecta-
tions of a rise in short-term interest rates. Fu rther along the y ield
cu rv e, the m ark et m ay ex pect a benign infl ationary env ironm ent,
w hich is w hy the prem iu m on longer term retu rns is low er than
norm al.
Figure 4.2 Negativ e y ield cu rv e fu nding.
Credit interm ediation by the repo desk

The gov ernm ent bond repo m ark et w ill trade at a low er rate than
other m oney m ark et instru m ents, refl ecting its statu s as a secu red
instru m ent w ith the best credit. This allow s spreads betw een
m ark ets of different credits to be ex ploited. The follow ing are
ex am ples of credit interm ediation trades:
a repo dealer lends general collateral cu rrently trading at a spread

below Libor and u ses the cash to bu y CDs trading at a sm aller
spread below Libor;
a repo dealer borrow s specifi c collateral in the stock -lending
m ark et – pay ing a fee – and sells the stock in the repo m ark et
at the GC rate; the cash is then lent in the interbank m ark et at a
higher rate – for instance, throu gh the pu rchase of a clearing bank
certifi cate of deposit. The CD is u sed as collateral in the stock
loan transaction. A bank m u st hav e dealing relationships w ith
both the stock loan and repo m ark ets to effect this trade. An
ex am ple of the trade that cou ld be pu t on u sing this ty pe of
interm ediation is show n in Figu re 4.3 for the UK gilt m ark et.
The details are giv en below and show that the bank w ou ld stand
to gain 17 basis points ov er the cou rse of the 3-m onth trade;
a repo dealer trades repo in the GC m ark et, and u sing the cash
from this repo inv ests in em erging m ark et collateral at a spread,
say , 400 basis points higher.
Thes e are bu t three ex am ples of the w ay that repo can be u sed to

Figure 4.3 Interm ediation betw een stock loan and repo m ark ets;
an ex am ple u sing UK gilts.
ex ploit the interest rate differentials that ex ist betw een m ark ets
of v ary ing credit qu alities and betw een secu red and u ns ecu red
m ark ets.
Figu re 4.3 show s potential gains that can be m ade by a repo-dealing

bank (m ark et-m ak er) that has access to both the stock loan and
general collateral repo m ark et. It illu strates the rates av ailable in
the gilt m ark et on 31 October 2000 for 3-m onth m atu rities, w hich
w ere
3-m onth GC repo 5.83–5.75%

1
3-m onth clearing bank CD 6 32 –6.00%
The stock loan fee for this term w as qu oted at 510 basis points, w ith
the actu al fee paid being 8 basis points. Therefore, the repo trader
borrow s GC stock for 3 m onths and offers this in repo at 5.75% ; 2 the
cash proceeds are then u sed to pu rchase a clearing bank CD at 6.00% .
This CD is u sed as collateral in the stock loan. The profi t is m ark et
risk -free as the term s are lock ed, althou gh there is an elem ent of
A repo dealer is a m ark et-m ak er, and so offers stock in repo at the offered
side, w hich is 5.75% . How ev er, this trade still tu rns in a profi t if the bank
dealt at another m ark et-m ak er’s bid side of 5.83% , w ith a profi t of 9 basis
points on the cash su m . Rates are qu oted from King & Shax son Bond
Brok ers Lim ited.
credit risk in holding the CD. On these term s, the profi t in £100
m illion stock for the 3-m onth period is approx im ately £170,000.
The m ain consideration for the dealing bank is the capital
requ irem ents of the trade. Gilt repo is zero-w eighted for capital
pu rposes; indeed, clearing bank CDs are accepted by the Bank of
England for liqu idity pu rposes, so the capital cost is not onerou s.
The bank w ill need to ensu re that it has su ffi cient credit lines for the
repo and CD cou nterparties.
SPECIALS TRADING
The ex istence of an open repo m ark et allow s the dem and for
borrow ing and lending stock s to be cleared by the price m echanism
– in this case the repo rate. This facility also m easu res su pply and
dem and for stock s m ore effi ciently than traditional stock lending.
It is to be ex pected that – w hen specifi c stock s are in dem and – the
prem iu m on obtaining them rises for a nu m ber of reasons. This is
refl ected in the repo rate associated w ith the specifi c stock in
dem and, w hich falls below the sam e m atu rity GC repo rate. The
repo rate falls becau se the entity repoing ou t stock – that is, borrow -
ing cash – is in possess ion of the desired asset: the specifi c bond. So,
the interest rate pay able by this cou nterparty falls as com pensation
for lending ou t the desired bond.
The factors contribu ting to indiv idu al secu rities becom ing special
inclu de
gov ernm ent bond au ctions ; the bond to be issu ed is shorted by
m ark et-m ak ers in anticipation of a new su pply of stock and du e
to client dem and;
ou tright short-selling, w hether deliberate position-tak ing on the
trader’s v iew , or m ark et-m ak ers selling stock on client dem and;
hedging, inclu ding bond u nderw riters w ho w ill short the
benchm ark gov ernm ent bond that the corporate bond is priced
against;
deriv ativ es trading su ch as basis (‘cash-and-carry ’) trading
creating dem and for a specifi c stock .
Natu ral holders of gov ernm ent bonds can benefi t from issu es going
special, w hich is w hen the dem and for specifi c stock s is su ch that
the rate for borrow ing them is redu ced. The low er repo rate refl ects
the prem iu m for borrow ing the stock . Note that the party borrow ing
Figure 4.4 Fu nding gain from repo of a special stock .
the special stock is lending cash; it is the rate pay able on the cash
that they hav e lent w hich is depressed.
The holder of a stock that has gone special can obtain cheap fu nding
for the issu e itself by lending it ou t. Alternativ ely , the holder can
lend the stock and obtain cash in ex change in a repo, for w hich the
rate pay able is low er than the interbank rate. Thes e fu nds can then be
lent ou t as either secu red fu nding (in a repo), or as u nsecu red fu nding,
enabling the specials holder to lock in a fu nding profi t. For ex am ple,
consider a situ ation w here a repo dealer holds an issu e that is trading
at 5.5% in 1-w eek repo. The equ iv alent GC rate is 7% , m ak ing the
specifi c issu e v ery special. By lending the stock ou t the dealer can
lock in the profi t by lending 1-w eek cash at 7% or at a higher rate in
the interbank m ark et. This is illu strated in Figu re 4.4.
There is a positiv e correlation betw een changes in a stock trading

ex pensiv e to the y ield cu rv e and changes in the degree to w hich it
trades special. Theory w ou ld predict this, since traders w ill m aintain
short positions for bonds w ith high fu nding (repo) costs only if the
anticipated fall in the price of the bond is large enou gh to cov er this
fu nding prem iu m . When stock is perceiv ed as being ex pensiv e – for
ex am ple, after an au ction annou ncem ent – this creates a dem and for
short positions and hence greater dem and for the paper in a repo.
At other tim es the stock m ay go tight in the repo m ark et, follow ing
w hich it w ill tend to be bid higher in the cash m ark et as traders close
ou t ex isting shorts (w hich had becom e ex pensiv e to fi nance). At the
sam e tim e traders and inv estors m ay attem pt to bu y the stock ou t-
right since it w ill now be cheap to fi nance in a repo. The link betw een
dearness in the cash m ark et and special statu s in the repo m ark et
fl ow s both w ay s.
MATCHED BOOK TRADING

The grow th and dev elopm ent of repo m ark ets has led to repo
m atched-book -trading desk s. Essentially , this is m ark et-m ak ing in
repo; dealers m ak e tw o-w ay trading prices in v ariou s secu rities,
irrespectiv e of their u nderly ing positions. The term ‘m atched
book ’ is in fact a m is nom er; m ost m atched book s are deliberately
m is m atched as part of a v iew on the short-term y ield cu rv e. Another
com m only encou ntered defi nition of the term is of a bank that trades
repo solely to cov er its long and short bond positions and does not
enter into trades for other reasons . 3 How ev er, it is not m atching cash
lent and borrow ed, nor trading to profi t from the bid–offer spread, nor
any of the su ndry other defi nitions that hav e been giv en in prev iou s
tex ts.
Traders ru nning a m atched book pu t on positions to tak e adv antage
of (i) short-term interest rate m ov em ents and (ii) anticipated su pply
and dem and in the u nderly ing stock . Many of the trading ideas and
strategies described in this book are ex am ples of m atched book
trading. It can inv olv e the follow ing ty pes of trade:
tak ing a v iew on interest rates – for ex am ple, the dealer bids for
1-m onth GC and offers 3-m onth GC, ex pecting the y ield cu rv e to
inv ert;
tak ing a v iew on specials – for ex am ple, the trader borrow s stock
in the stock -lending m ark et for u s e in repo once it goes special (as
the trader ex pects);
credit interm ediation – for ex am ple, a dealer rev erses in Brady
bonds from a Latin Am erican bank , at a rate of Libor 200 and
offers this stock to a US m oney m ark et inv estor at a rate of
Libor 20.
Principals and principal interm ediaries w ith large v olu m es of repos
and rev erse repos, su ch as the m ark et-m ak ers m entioned abov e, are
said to be ru nning m atched book s . An u ndertak ing to prov ide tw o-
w ay prices is m ade to prov ide cu stom ers w ith a continu ou s fi nancing
Thank s to Del Boy at King & Shax son Bond Brok ers Ltd for pointing this
ou t, althou gh I still reck on that m y defi nition is the right one!
serv ice for long and short positions and also as part of proprietary
trading. Traders w ill m ism atch positions in order to tak e adv antage
of a com bination of tw o factors: short-term interest rate m ov em ents
and anticipated su pply /dem and in the u nderly ing bond.
INTEREST-RATE-HEDGING TOOLS
For bank dealers w ho are not look ing to trade arou nd term m ism atch
or other spreads, bu t w ho w ill ru n a tenor m is m atch betw een assets
and liabilities (w hich is, after all, w hat bank ing is: the practice of
m atu rity transform ation), there are a nu m ber of instru m ents w e can
u se to hedge the resu lting interest rate risk ex posu re. We briefl y
consider them here. They are cov ered in greater depth in Chou dhry
(2007).
Interest rate futures

A forw ard term interest rate gap ex posu re can be hedged u sing
interest rate fu tu res. Thes e are standardized ex change-traded
deriv ativ e contracts, and represent a forw ard-starting 90-day tim e
deposit. In the sterling m ark et the instru m ent w ill be ty pically the
90-day short sterling fu tu re traded on the LIFFE fu tu res ex change.
A strip of fu tu res can be u sed to hedge the term gap. The trader bu y s
fu tu res contracts to the v alu e of the ex posu re and for the term of the
gap. Any change in cash rates shou ld be hedged by offsetting m ov es
in fu tu res prices .
Description
A futures contract is a transaction that fi x es the price today for a
com m odity that w ill be deliv ered at som e point in the fu tu re.
Financial fu tu res fi x the price for interest rates, bonds , equ ities
and so on, bu t trade in the sam e m anner as com m odity fu tu res.
Contracts for fu tu res are standardized and traded on recognized
ex changes. In London the m ain fu tu res ex change is LIFFE, althou gh
other fu tu res are also traded on, for ex am ple, the International
Petroleu m Ex change and the London Metal Ex change. Money
m ark ets trade short-term interest rate fu tu res that fi x the rate of
interest on a notional fi x ed term deposit of m oney (u su ally for 90
day s or 3 m onths) for a specifi ed period in the fu tu re. The su m is
notional becau se no actu al su m of m oney is deposited w hen bu y ing
Table 4.1 Description of LIFFE short sterling fu tu re

contract
Nam e 90-day sterling Libor interest rate fu tu re
Contract size £500,000
Deliv ery m onths March, Ju ne, Septem ber, Decem ber
Deliv ery date First bu siness day after the last trading day
Last trading day Third Wednesday of deliv ery m onth
Price 100 m inu s interest rate
Tick size 0.01
Tick v alu e £12.50
Trading hou rs LIFFE CONNECT TM 07:30–18:00 hou rs
Source: LIFFE.
or selling fu tu res – the instru m ent being off balance sheet. Bu y ing
su ch a contract is equ iv alent to m ak ing a notional deposit, w hile
selling a contract is equ iv alent to borrow ing a notional su m .
The 3-m onth interest rate fu tu re is the m ost w idely u sed instru m ent
for hedging interest rate risk .
The LIFFE ex change in London trades short-term interest rate

fu tu res for m ajor cu rrencies inclu ding sterling, eu ros, y en and the
Sw is s franc. Table 4.1 su m m arizes the term s for the short sterling
contract as traded on LIFFE.
Fu tu res contracts originally related to phy sical com m odities, w hich

is w hy w e speak of delivery w hen referring to the ex piry of fi nancial
fu tu res contracts. Ex change-traded fu tu res su ch as those on LIFFE
are set to ex pire ev ery qu arter du ring the y ear. The short sterling
contract is a deposit of cash, so as its price refers to the rate of interest
on this deposit the price of the contract is set as P 100 r w here P
is the price of the contract and r is the rate of interest at the tim e of
ex piry im plied by the fu tu res contract. This m eans that if the price of
the contract rises the rate of interest im plied goes dow n and v ice
v ersa. For ex am ple, the price of the Ju ne 2011 short sterling fu tu re
(w ritten as Ju n11 or M11, from the fu tu res identity letters of H, M, U
and Z for contracts ex piring in March, Ju ne, Septem ber and Decem -
ber, respectiv ely ) at the start of trading on 22 Septem ber 2010 w as
99.05, w hich im plied a 3-m onth Libor rate of 0.95% on ex piry of the
contract in Ju ne 2011. If a trader bou ght 20 contracts at this price and
then sold them ju st before the close of trading that day , w hen the
price had risen to 99.08, an im plied rate of 0.92% , she w ou ld hav e
m ade 3 tick s profi t or £750. That is, a 3-tick u pw ard price m ov em ent
in a long position of 20 contracts is equ al to £750. This is calcu lated
as follow s:
Profit Tick s gained Tick v alu e Nu m ber of contracts
Loss Tick s lost Tick v alu e Nu m ber of contracts
The tick v alu e for the short sterling contract is straightforw ard to
calcu late. Since w e k now that the contract size is £500,000, there is
a m inim u m price m ov em ent (tick m ov em ent) of 0.01% and the
contract has a 3-m onth ‘m atu rity ’:
3
Tick v alu e 0 01% £500,000 £12 50
12
The profi t m ade by the trader in ou r ex am ple is logical becau se if w e
bu y short sterling fu tu res w e are depositing (notional) fu nds and if
the price of the fu tu res rises, it m eans the interest rate has fallen.
We profi t becau se w e hav e ‘deposited’ fu nds at a higher rate before-
hand. If w e ex pected sterling interest rates to rise, w e w ou ld sell short
sterling fu tu res, w hich is equ iv alent to borrow ing fu nds and lock ing
in the loan rate at a low er lev el.
Note how the concept of bu y ing and selling interest rate fu tu res
differs from FRAs: if w e bu y a FRA w e are borrow ing notional
fu nds, w hereas if w e bu y a fu tu res contract w e are depositing
notional fu nds. If a position in an interest rate fu tu res contract is
held to ex piry , cash settlem ent w ill tak e place on the deliv ery day for
that contract.
Short-term interest rate contracts in other cu rrencies are sim ilar to
the short sterling contract and trade on ex changes su ch as Deu ts che
Term inbörse in Frank fu rt and MATIF in Paris.
In practice, fu tu res contracts do not prov ide a precise tool for lock ing
into cash m ark et rates today for a transaction that tak es place in the
fu tu re, althou gh this is w hat they are theoretically designed to do.
Fu tu res do allow a bank to lock in a rate for a transaction to tak e place
in the fu tu re; this rate is the forward rate. The basis is the difference
betw een today ’s cash m ark et rate and the forw ard rate on a particu lar
date in the fu tu re. As a fu tu res contract approaches ex piry , its price
and the rate in the cash m ark et w ill conv erge (the process is giv en the
nam e convergence). This is giv en by the ex change deliv ery settle-
m ent price, and the tw o prices (rates) w ill be ex actly in line at the
precise m om ent of ex piry .
Example 4.1 The Eu rodollar fu tu res contract
The Eu rodollar fu tu res contract is traded on the Chicago

Mercantile Ex change. The u nderly ing asset is a deposit of US
dollars in a bank ou tside the US, and the contract is at the rate of
dollar 90-day Libor. The Eu rodollar fu tu re is cash-settled on the
second bu s iness day before the third Wednesday of the deliv ery
m onth (London bu s iness day ). The fi nal settlem ent price is u s ed to
set the price of the contract, giv en by
10,000 100 0 25r
w here r is the qu oted Eu rodollar rate at the tim e. This rate is the
actu al 90-day Eu rodollar deposit rate.
The longest dated Eu rodollar contract has an ex piry date of 10
y ears. The m ark et assu m es that fu tu res prices and forw ard prices
are equ al; this is indeed the case u nder conditions w here the risk -
free interest rate is constant and the sam e for all m atu rities. In
practice, it also holds for short-dated fu tu res contracts, bu t does
not for longer dated fu tu res contracts. Therefore, u s ing fu tu res
contracts w ith a m atu rity greater than 5 y ears to calcu late zero-
cou pon rates or im plied forw ard rates w ill produ ce errors in
resu lts, w hich need to be tak en into accou nt if the deriv ed rates
are u sed to price other instru m ents su ch as sw aps .
Figu re 4.5 show s the Bloom berg description page for the Eu rodollar
contract.
Figure 4.5 Bloom berg page DES for Eu rodollar contract.

Bloom berg L.P. Used w ith perm iss ion.
Hedging using interest rate futures

Bank s u se interest rate fu tu res to hedge interest rate risk ex posu re in
cash and OBS instru m ents. Bond-trading desk s often u se fu tu res to
hedge positions in bonds of u p to 2 or 3 y ears’ m atu rity , as contracts
are traded u p to 3 y ears’ m atu rity . The liqu idity of su ch ‘far m onth’
contracts is considerably low er than for ‘near m onth’ contracts and
the ‘front m onth’ contract (the cu rrent contract, for the nex t m atu r-
ity m onth). When hedging a bond w ith a m atu rity of say 2 y ears’
m atu rity , the trader w ill pu t on a strip of fu tu res contracts that
m atches as near as possible the ex piry date of the bond.
The pu rpose of a hedge is to protect the v alu e of a cu rrent or
anticipated cash m ark et or OBS position from adv erse changes in
interest rates. The hedger w ill try to offset the effect of the change in
interest rate on the v alu e of his cash position w ith the change in
v alu e of his hedging instru m ent. If the hedge is an ex act one the loss
on the m ain position shou ld be com pensated by a profi t on the hedge
position. If the trader is ex pecting a fall in interest rates and w ishes to
protect against su ch a fall he w ill bu y fu tu res (k now n as a long hedge)
and w ill sell fu tu res (a short hedge) if w ishing to protect against a rise
in rates.
Bond traders also u s e 3-m onth interest rate contracts to hedge
positions in short-dated bonds; for instance, a m ark et-m ak er
ru nning a short-dated bond book w ou ld fi nd it m ore appropriate
to hedge his book u sing short-dated fu tu res rather than the longer
dated bond fu tu res contract. When this happens it is im portant to
accu rately calcu late the correct nu m ber of contracts to u se for the
hedge. To constru ct a bond hedge it w ill be necessary to u se a strip of
contracts, thu s ensu ring that the m atu rity date of the bond is cov ered
by the longest dated fu tu res contract. The hedge is calcu lated by
fi nding the sensitiv ity of each cashfl ow to changes in each of the
relev ant forw ard rates. Each cashfl ow is considered indiv idu ally and
hedge v alu es are then aggregated and rou nded to the nearest w hole
nu m ber of contracts.
Ex am ples 4.2 and 4.3 illu strate hedging w ith short-term interest-rate
contracts.
Example 4.2 Hedging a forw ard 3-m onth lending requ irem ent
On 1 Ju ne a corporate treasu rer is ex pecting a cash infl ow of £10

m illion in 3 m onths’ tim e (1 Septem ber), w hich he w ill then inv est
for 3 m onths. The treasu rer ex pects interest rates w ill fall ov er the
nex t few w eek s and w is hes to protect him s elf against su ch a fall.
This can be done u sing short sterling fu tu res. The m ark et rates on
1 Ju ne are as follow s:
3-m onth Libor 6 12 %

Sep fu tu res price 93.220
The treasu rer bu y s 20 Septem ber short sterling fu tu res at 93.220,

this nu m ber being ex actly equ iv alent to a su m of £10 m illion. This
allow s him to lock in a forw ard lending rate of 6.78% , on the
assu m ption there is no bid–offer qu ote spread:
Ex pected lending rate Rate im plied by fu tu res price
100 93 220
6 78%
On 1 Septem ber the m ark et rates are as follow s:
3-m onth Libor 6 12 %

Sep fu tu res price 93.705
The treasu rer u nw inds the hedge at this price.

Fu tu res P& L 97 tick s 93 705 93 22 or 0 485%
Effectiv e lending rate 3-m onth Libor Fu tu res profit
6 25% 0 485%
6 735%
The treasu rer w as qu ite close to achiev ing his target lending rate of
6.78% and the hedge has helped to protect against the drop in Libor
rates from 6 12 % to 6 14 % , as a resu lt of the profi t from the fu tu res
transaction.
In the real w orld the cash m ark et bid–offer spread w ill im pact the
am ou nt of profi t/loss from the hedge transaction. Fu tu res gen-
erally trade and settle near the offered side of the m ark et rate
(Libor) w hereas lending, certainly by corporates, w ill be nearer the
Libid rate.
Example 4.3 Hedging a forw ard 6-m onth borrow ing requ irem ent
A Treasu ry dealer has a 6-m onth borrow ing requ irem ent for
EUR30 m illion in 3 m onths’ tim e, on 16 Septem ber. He ex pects
interest rates to rise by at least 12 % before that date and w ou ld lik e
to lock in a fu tu re borrow ing rate. The scenario is:
Date 16 Ju ne
3-m onth LIBOR 6.0625%
6-m onth LIBOR 6.25
Sep fu tu res contract 93.66
Dec fu tu res contract 93.39
In order to hedge a 6-m onth DEM30 m illion ex posu re the dealer
needs to u se a total of 60 fu tu res contracts, as each has a nom inal
v alu e of EUR1 m illion, and corresponds to a 3-m onth notional
deposit period. The dealer decides to sell 30 Septem ber fu tu res
contracts and 30 Decem ber fu tu res contracts. This is referred to as
a strip hedge. The ex pected forw ard borrow ing rate that can be
achiev ed by this strategy , w here the ex pected borrow ing rate is rf,
is calcu lated as follow s:
Day s in period Sep day s period
1 rf 1 Sep im plied rate
360 360
Dec day s period
1 Dec im plied rate
360
Therefore, w e hav e:
180 90 90
1 rf 1 0 0634 1 0 0661
360 360 360
6 53%
The rate rf is som etim es referred to as the ‘strip rate’ .
The hedge is u nw ou nd u pon ex piry of the Septem ber fu tu res
contract. Ass u m e the follow ing rates now prev ail:
3-m onth LIBOR 6.4375%
6-m onth LIBOR 6.8125
Sep fu tu res contract 93.56
Dec fu tu res contract 92.93
The fu tu res P&L is:
Septem ber contract 10 tick s
Decem ber contract 46 tick s
This represents a 56-tick or 0.56% profi t in 3-m onth interest rate

term s, or 0.28% in 6-m onth interest rate term s. The effectiv e
borrow ing rate is the 6-m onth LIBOR rate m inu s the fu tu res profi t,
or:
6 8125% 0 28% or 6 5325%
In this case the hedge has prov ed effectiv e becau se the dealer has
realized a borrow ing rate of 6.5325% , w hich is close to the target
strip rate of 6.53% .
The dealer is still ex posed to the basis risk w hen the Decem ber
contracts are bou ght back from the m ark et at the ex piry date of the
Septem ber contract. If, for ex am ple, the fu tu re w as bou ght back at
92.73, the effectiv e borrow ing rate w ou ld only be 6.4325% , and the
dealer w ou ld benefi t. Of cou rse, the other possibility is that the
fu tu res contract cou ld be trading 20 tick s m ore ex pensiv e, w hich
w ou ld giv e a borrow ing rate of 6.6325% , w hich is 10 basis points
abov e the target rate. If this happened, the dealer m ay elect to
borrow in the cash m ark et for 3 m onths, m aintain the Decem ber
fu tu res position u ntil the Decem ber contract ex piry date, and roll
ov er the borrow ing at that tim e. The profi t (or loss) on the
Decem ber fu tu res position w ill com pensate for any change in
3-m onth rates at that tim e.
Forw ard rate agreem ents

Forward rate agreements (FRAs) are sim ilar in concept to interest
rate fu tu res and lik e them are off-balance-sheet instru m ents . Under
a FRA a bu y er agrees notionally to borrow and a seller to lend a
specifi ed notional am ou nt at a fi x ed rate for a specifi ed period – the
contract to com m ence on an agreed date in the fu tu re. On this date
(the ‘fi x ing date’) the actu al rate is tak en and, according to its
position v ersu s the original trade rate, the borrow er or lender w ill
receiv e an interest pay m ent on the notional su m equ al to the dif-
ference betw een the trade rate and the actu al rate. The su m paid ov er
is present-v alu ed as it is transferred at the start of the notional loan
period, w hereas in a cash m ark et trade interest w ou ld be handed ov er
at the end of the loan period. As FRAs are off-balance-sheet contracts
no actu al borrow ing or lending of cash tak es place, hence the u se of
the term ‘notional’. In hedging an interest rate gap in the cash period,
the trader w ill bu y a FRA contract that equ ates to the term gap for a
nom inal am ou nt equ al to his ex posu re in the cash m ark et. Shou ld
rates m ov e against him in the cash m ark et, the gain on the FRA
shou ld (in theory ) com pensate for the loss in the cash trade.
Definition of a FRA
A FRA is an agreem ent to borrow or lend a notional cash su m for a
period of tim e lasting u p to 12 m onths, starting at any point ov er the
nex t 12 m onths, at an agreed rate of interest (the FRA rate). The
‘bu y er’ of a FRA is borrow ing a notional su m of m oney w hile the
‘seller’ is lending this cash su m . Note how this differs from all other
m oney m ark et instru m ents . In the cash m ark et, the party bu y ing a
CD or bill, or bidding for stock in the repo m ark et, is the lender of
fu nds. In the FRA m ark et, to ‘bu y ’ is to ‘borrow ’. Of cou rse, w e u se
the term ‘notional’ becau se w ith a FRA no borrow ing or lending of
cash actu ally tak es place. The notional su m is sim ply the am ou nt on
w hich interest pay m ent is calcu lated.
So, w hen a FRA is traded, the bu y er is borrow ing (and the seller is
lending) a specifi ed notional su m at a fi x ed rate of interest for a
specifi ed period – the ‘loan’ to com m ence at an agreed date in the
fu tu re. The buyer is the notional borrow er, and so she w ill be
protected if there is a rise in interest rates betw een the date that
the FRA is traded and the date that the FRA com es into effect. If there
is a fall in interest rates, the bu y er m u st pay the difference betw een
the rate at w hich the FRA w as traded and the actu al rate, as a
percentage of the notional su m . The bu y er m ay be u sing the FRA
to hedge an actu al ex posu re – that is, an actu al borrow ing of m oney –
or sim ply specu lating on a rise in interest rates. The cou nterparty to
the transaction, the seller of the FRA, is the notional lender of fu nds,
and has fi x ed the rate for lending fu nds. If there is a fall in interest
rates the seller w ill gain, and if there is a rise in rates the seller w ill
pay . Again, the seller m ay hav e an actu al loan of cash to hedge or be a
specu lator.
In FRA trading only the pay m ent that arises as a resu lt of the
difference in interest rates changes hands. There is no ex change of
cash at the tim e of the trade. The cash pay m ent that does arise is the
difference in interest rates betw een that at w hich the FRA w as traded
and the actu al rate prev ailing w hen the FRA m atu res, as a percentage
of the notional am ou nt. FRAs are traded by both bank s and corpo-
rates and betw een bank s. The FRA m ark et is v ery liqu id in all m ajor
cu rrencies and rates are readily qu oted on screens by both bank s and
brok ers. Dealing is ov er the telephone or ov er a dealing sy stem su ch
as Reu ters.
The term inology qu oting FRAs refers to the borrow ing tim e period
and the tim e at w hich the FRA com es into effect (or m atu res). Hence,
if a bu y er of a FRA w ished to hedge against a rise in rates to cov er a
3-m onth loan starting in 3 m onths’ tim e, she w ou ld transact a
‘3-against-6-m onth’ FRA, m ore u su ally denoted as a 3 6 or 3v 6
FRA. This is referred to in the m ark et as a ‘threes–six es’ FRA, and
m eans a 3-m onth loan beginning in 3 m onths’ tim e. So, correspond-
ingly , a ‘ones–fou rs’ FRA (1v 4) is a 3-m onth loan in 1 m onth’ s tim e,
and a ‘threes–nines’ FRA (3v 9) is a 6-m onth loan in 3 m onths’ tim e.
Rem em ber that w hen w e bu y a FRA w e are ‘borrow ing’ fu nds. This
differs from cash produ cts su ch as CD or repo, as w ell as interest rate
fu tu res, w here to ‘bu y ’ is to lend fu nds.
Example 4.4 FRA hedging
A com pany k now s that it w ill need to borrow £1 m illion in

3 m onths’ tim e for a 12-m onth period. It can borrow fu nds today at
Libor 50 basis points. Libor rates today are at 5% bu t the
com pany ’s treasu rer ex pects rates to go u p to abou t 6% ov er the
nex t few w eek s. So, the com pany w ill be forced to borrow at higher
rates u nless som e sort of hedge is transacted to protect the
borrow ing requ irem ent. The treasu rer decides to bu y a 3v 15
(‘threes –fi fteens ’) FRA to cov er the 12-m onth period beginning
3 m onths from now . A bank qu otes 5 12 % for the FRA w hich the
com pany bu y s for a notional £1 m illion. After 3 m onths the rates
hav e indeed gone u p to 6% , so the treasu rer m u st borrow fu nds at
6 12 % (the Libor rate plu s spread); how ev er, she w ill receiv e a
settlem ent am ou nt w hich w ill be the difference betw een the
rate at w hich the FRA w as bou ght and today ’s 12-m onth Libor
rate (6% ) as a percentage of £1 m illion, w hich w ill com pensate for
som e of the increased borrow ing costs.
FRA m echanics
In v irtu ally ev ery m ark et FRAs trade u nder a set of term s and
conv entions that are identical. The British Bank ers Association
(BBA) has com piled standard legal docu m entation to cov er FRA
trading. The follow ing standard term s are u sed in the m ark et:
N otional sum – the am ou nt for w hich the FRA is traded.
Trade date – the date on w hich the FRA is dealt.
Settlement date – the date on w hich the notional loan or deposit
of fu nds becom es effectiv e; that is, is said to begin. This date is

u sed, in conju nction w ith the notional su m , for calcu lation
pu rposes only as no actu al loan or deposit tak es place.
Fixing date – this is the date on w hich the reference rate is
determ ined; that is, the rate w ith w hich the FRA dealing rate
is com pared.
Maturity date – the date on w hich the notional loan or deposit
ex pires.
C ontract period – the tim e betw een the settlem ent date and
m atu rity date.
FRA rate – the interest rate at w hich the FRA is traded.
Reference rate – the rate u s ed as part of the calcu lation of the
settlem ent am ou nt, u su ally the Libor rate on the fi x ing date for
the contract period in qu estion.
Settlement sum – the am ou nt calcu lated as the difference
betw een the FRA rate and the reference rate as a percentage of
the notional su m , paid by one party to the other on the settlem ent
date.
Thes e dates are illu strated in Figu re 4.6.
The spot date is u su ally tw o bu sines s day s after the trade date;
how ev er, it can by agreem ent be sooner or later than this. The
settlem ent date w ill be the tim e period after the spot date referred
to by FRA term s – for ex am ple, a 1 4 FRA w ill hav e a settlem ent
date one calendar m onth after the spot date. The fi x ing date is
u su ally tw o bu sines s day s before the settlem ent date. The settle-
m ent su m is paid on the settlem ent date and, as it refers to an
am ou nt ov er a period of tim e that is paid u pfront at the start of
the contract period, the calcu lated su m is a discou nted present
v alu e. This is becau se a norm al pay m ent of interest on a loan/
deposit is paid at the end of the tim e period to w hich it relates.
Becau se a FRA m ak es this pay m ent at the start of the relev ant
period, the settlem ent am ou nt is also a discou nted present v alu e
su m .
Figure 4.6 Key dates in a FRA trade.

With m ost FRA trades the reference rate is the LIBOR setting on the
fi x ing date.
The settlem ent su m is calcu lated after the fi x ing date, for pay m ent
on the settlem ent date. We m ay illu strate this w ith a hy pothetical
ex am ple. Consider the case w here a corporate has bou ght £1 m illion
notional of a 1v 4 FRA and dealt at 5.75% , and that the m ark et rate
is 6.50% on the fi x ing date. The contract period is 90 day s. In the cash
m ark et the ex tra interest charge that the corporate w ou ld pay is a
sim ple interest calcu lation:
6 50 5 75 91
1,000,000 £1,869 86
100 365
The ex tra interest that the corporate is facing w ou ld be pay able w ith
the interest pay m ent for the loan, w hich (as it is a m oney m ark et
loan) is w hen the loan m atu res. Under a FRA then, the settlem ent
su m pay able shou ld be ex actly equ al to this if it w as paid on the sam e
day as the cash m ark et interest charge. This w ou ld m ak e it a perfect
hedge. How ev er, as w e noted abov e, the FRA settlem ent v alu e is paid
at the start of the contract period – that is, at the beginning of the
u nderly ing loan and not the end. Therefore, the settlem ent su m has
to be adju sted to accou nt for this, and the am ou nt of the adju stm ent
is the v alu e of the interest that w ou ld be earned if the u nadju sted
cash v alu e w as inv ested for the contract period in the m oney m ark et.
The settlem ent v alu e is giv en by equ ation (4.1):
n
rref rF R A M
Settlem ent B 41
n
1 rref
B
w here
rref Reference interest fi x ing rate;
rF R A FRA rate or contract rate;
M Notional v alu e;
n Nu m ber of day s in the contract period;
B Day -cou nt base (360 or 365).
Equ ation (4.1) sim ply calcu lates the ex tra interest pay able in the cash
m ark et, resu lting from the difference betw een the tw o interest rates,
and then discou nts the am ou nt becau se it is pay able at the start of
the period and not, as w ou ld happen in the cash m ark et, at the end of
the period.
In ou r hy pothetical illu stration, the corporate bu y er of the FRA
receiv es the settlem ent su m from the seller as the fi x ing rate is
higher than the dealt rate. This then com pensates the corporate for
the higher borrow ing costs that he w ou ld hav e to pay in the cash
m ark et. If the fi x ing rate had been low er than 5.75% , the bu y er
w ou ld pay the difference to the seller, becau se cash m ark et rates
w ill m ean that he is su bject to a low er interest rate in the cash
m ark et. What the FRA has done is hedge the interest rate, so that
w hatev er happens in the m ark et, it w ill pay 5.75% on its borrow ing.
A m ark et-m ak er in FRAs is trading short-term interest rates. The
settlem ent su m is the v alu e of the FRA. The concept is ex actly the
sam e as w ith trading short-term interest rate fu tu res; a trader w ho
bu y s a FRA is ru nning a long position, so that if rref rF R A on the
fi x ing date the settlem ent su m is positiv e and the trader realizes a
profi t. What has happened is that the trader, by bu y ing the FRA,
‘borrow ed’ m oney at an interest rate that su bsequ ently rose. This is a
gain, ex actly lik e a short position in an interest rate fu tu re, w here if
the price goes dow n – that is, interest rates go u p – the trader realizes
a gain. Equ ally a ‘short’ position in a FRA, pu t on by selling a FRA,
realizes a gain if rref rF R A on the fi x ing date.
FRA pricing
As their nam e m ak es clear, FRAs are forw ard rate instru m ents and
are priced u sing standard forw ard rate principles. 4 Consider an
inv estor w ho has tw o alternativ es : either a 6-m onth inv estm ent
at 5% or a 1-y ear inv estm ent at 6% . If the inv estor w ishes to
inv est for 6 m onths and then roll ov er the inv estm ent for a
fu rther 6 m onths, w hat rate is requ ired for the rollov er period
su ch that the fi nal retu rn equ als the 6% av ailable from the 1-y ear
inv estm ent? If w e v iew a FRA rate as the break ev en forw ard rate
betw een the tw o periods, w e sim ply solv e for this forw ard rate.
The resu lt is ou r approx im ate FRA rate.
We can u se the standard forw ard rate break ev en form u la to solv e for
the requ ired FRA rate. The relationship giv en in equ ation (4.2) con-
nects sim ple (bu llet) interest rates for periods of tim e u p to 1 y ear,
w here no com pou nding of interest is requ ired. As FRAs are m oney
m ark et instru m ents w e are not requ ired to calcu late rates for periods
An introdu ction to the basics of spot and forw ard rates can be fou nd in any
nu m ber of fi nance tex tbook s; the au thor particu larly lik es Windas (1993)
and Fabozzi and Mann (2001), both of w hich are highly su itable for
beginners.
Figure 4.7 Rates u sed in FRA pricing.
in ex cess of 1 y ear,5 w here com pou nding w ou ld need to be bu ilt into

the equ ation. The ex pression is:
1 r2 t2 1 r1 t1 1 rf tf 42
w here
r2 Cash m ark et interest rate for the long period;
r1 Cash m ark et interest rate for the short period;
rf Forw ard rate for the gap period;
t2 Tim e period from today to the end of the long period;
t1 Tim e period from today to the end of the short period;
tf Forw ard gap tim e period, or the contract period for the FRA.
This is illu strated diagram m atically in Figu re 4.7.
The tim e period t1 is the tim e from the dealing date to the FRA
settlem ent date, w hile t2 is the tim e from the dealing date to the
FRA m atu rity date. The tim e period for the FRA (contract period) is t2
m inu s t1 . We can replace the sy m bol ‘t’ for tim e period w ith ‘n’ for
the actu al nu m ber of day s in the tim e periods them selv es. If w e do
this and then rearrange the equ ation to solv e for rF R A (the FRA rate)
w e obtain:
r2 n2 r1 n1
rF R A n1 43
nF R A 1 r1
365
w here
n1 Nu m ber of day s from the dealing date or spot date to the
settlem ent date;
n2 Nu m ber of day s from the dealing date or spot date to the
m atu rity date;
Althou gh it is of cou rse possible to trade FRAs w ith contract periods

greater than 1 y ear, for w hich a different pricing form u la m u st be u sed.
r1 Spot rate to the settlem ent date;

r2 Spot rate from the spot date to the m atu rity date;
nF R A Nu m ber of day s in the FRA contract period;
rF R A FRA rate.
If the form u la is applied to, say , US dollar m oney m ark ets, the 365
in the equ ation is replaced by 360, the day -cou nt base for that
m ark et.
In practice, FRAs are priced off the ex change-traded short-term
interest rate fu tu re for that cu rrency , so that sterling FRAs are
priced off LIFFE short sterling fu tu res. Traders norm ally u se a spread-
sheet pricing m odel that has fu tu res prices directly fed into it. FRA
positions are also u su ally hedged w ith other FRAs or short-term
interest rate fu tu res.
Interest rate swaps

An interest rate sw ap is an off-balance-sheet agreem ent betw een tw o
parties to m ak e periodic interest pay m ents to each other. Pay m ents
are on a predeterm ined set of dates in the fu tu re, based on a notional
principal am ou nt; one party is the fixed rate payer, the rate agreed at
the start of the sw ap, and the other party is the floating rate payer, the
fl oating rate being determ ined du ring the life of the sw ap by refer-
ence to a specifi c m ark et rate or index . There is no ex change of
principal, only of the interest pay m ents on this principal am ou nt.
Note that ou r description is for a plain v anilla sw ap contract; it is
com m on to hav e v ariations on this them e – for instance, floating–
floating sw aps w here both pay m ents are fl oating rate, as w ell as
cross-currency sw aps w here there is an ex change of an equ al
am ou nt of different cu rrencies at the start dates and end dates of
the sw ap.
An interest rate sw ap can be u sed to hedge the fi x ed rate risk arising
from originating a loan at a fi x ed interest rate, su ch as a fi x ed rate
m ortgage. The term s of the sw ap shou ld m atch the pay m ent dates
and m atu rity date of the loan. The idea is to m atch the cashfl ow s
from the loan w ith equ al and opposite pay m ents in the sw ap con-
tract, w hich w ill hedge the m ortgage position. For ex am ple, if the
retail bank has adv anced a fi x ed rate m ortgage, it w ill be receiv ing
fi x ed rate cou pon pay m ents on the nom inal v alu e of the loan
(together w ith a portion of the capital repay m ent if it is a repay m ent
m ortgage and not an interest-only m ortgage). To hedge this position
the trader bu y s a sw ap contract for the sam e nom inal v alu e in w hich
he w ill be pay ing the sam e fi x ed rate pay m ent; net cashfl ow is a
receipt of fl oating interest rate pay m ents .
A borrow er, on the other hand, m ay issu e bonds of a particu lar ty pe
becau se of inv estor dem and for su ch paper, bu t prefer to hav e the
interest ex posu re on the debt in som e other form . So, for ex am ple, a
UK com pany issu es fi x ed rate bonds denom inated in, say , Au stralian
dollars, sw aps the proceeds into sterling and pay s fl oating rate
interest on the sterling am ou nt. As part of the sw ap the com pany
w ill be receiv ing fi x ed rate Au stralian dollars w hich neu tralizes the
ex posu re arising from the bond issu e. On term ination of the sw ap
(w hich m u st coincide w ith the m atu rity of the bond) the original
cu rrency am ou nts are ex changed back , enabling the issu er to redeem
the holders of the bond in Au stralian dollars.
For detailed cov erage of interest rate sw aps and their application see
Chou dhry (2007).
Description
Swaps are deriv ativ e contracts inv olv ing com binations of tw o or
m ore interest rate bases or other bu ilding block s. Most sw aps cu r-
rently traded in the m ark et inv olv e com binations of cash m ark et
secu rities – for ex am ple, a fi x ed interest rate secu rity com bined w ith
a fl oating interest rate secu rity , possibly also com bined w ith a cu r-
rency transaction. How ev er, the m ark et has also seen sw aps that
inv olv e a fu tu res or forw ard com ponent, as w ell as sw aps that
inv olv e an option com ponent. The m ark et for sw aps is organized
by the International Sw aps and Deriv ativ es Association (ISDA).
Example 4.5 Com parativ e adv antage and interest rate sw ap

stru ctu re
When entering into a sw ap either for hedging pu rposes or to alter

the basis of an interest rate liability , the opposite of a cu rrent
cashfl ow profi le is requ ired. Consider a hom eow ner w ith a v ariable
rate m ortgage. The hom eow ner is at risk from an u pw ard m ov e in
interest rates, w hich w ill resu lt in her being charged higher
interest pay m ents. She w ishes to protect herself against su ch a
m ov e and in theory (Don’t try this w ith y ou r bu ilding society !), as
she is paying floating, she m u st receive floating in a sw ap.
Therefore, she w ill pay fi x ed in the sw ap. The fl oating interest
pay m ents cancel each other ou t, and the hom eow ner now has a
fi x ed rate liability . The sam e applies in a hedging transaction: a
bondholder receiving fixed cou pons from the bond issu er – that is,
the bondholder is a lender of fu nds – can hedge against a rise in
interest rates that low ers the price of the bond by paying fixed in a
sw ap w ith the sam e basis point v alu e as the bond position; the
bondholder receiv es fl oating interest. Paying fixed in a sw ap is
conceptu ally the sam e as being a borrower of funds; this borrow ing
is the opposite of a loan of fu nds to the bond issu er and therefore
the position is hedged. Consider tw o com panies’ borrow ing costs
for a 5-y ear loan of £50 m illion:
C ompany A can pay fi x ed at 8.75% or fl oating at Libor. Its

desired basis is fl oating.
C ompany B can pay fi x ed at 10% or fl oating at Libor 100
basis points. Its desired basis is fi x ed.
Withou t a sw ap:
Com pany A borrow s fi x ed and pay s 8.75% ;

Com pany B borrow s fl oating and pay s Libor 100 basis points.
Let u s say that the tw o com panies decide to enter into a sw ap,
w hereby Com pany A borrow s fl oating rate interest and therefore
receiv es fi x ed from Com pany B at the 5-y ear sw ap rate of 8.90% .
Com pany B, w hich has borrow ed at Libor 100 basis points, pay s
fi x ed and receiv es Libor in the sw ap. Com pany A ends u p pay ing
fl oating rate interest, and com pany B ends u p pay ing fi x ed.
The resu lt after the sw ap:

A pay s 8 75% Libor 8 90% Libor 15 bp
B pay s Libor 100 bp 8 90% Libor 9 90%
Com pany A sav es 15 basis points (pay s L 15 bp rather than L fl at)
and B sav es 10 basis points (pay s 9.90% rather than 10% ).
Both parties benefi t from the comparative advantage of A in the

fi x ed rate m ark et and B in the fl oating rate m ark et (spread of B ov er
A is 125 bp in the fi x ed rate m ark et bu t 100 bp in the fl oating rate
m ark et). Originally sw ap bank s w ere sim ply brok ers, and charged
a fee to both cou nterparties for bringing them together. In the
ex am ple Com pany A deals direct w ith Com pany B, althou gh it is
m ore lik ely that an interm ediary bank w ou ld hav e been inv olv ed.
As the m ark et dev eloped, bank s becam e principals and dealt direct
w ith cou nterparties, elim inating the need to fi nd som eone w ho
had requ irem ents that cou ld be m et by the other side of an ex isting
requ irem ent.
An interest rate sw ap is an agreem ent betw een tw o cou nterparties to

m ak e periodic interest pay m ents to one another du ring the life of the
sw ap, on a predeterm ined set of dates, based on a notional principal
am ou nt. One party is the fi x ed rate pay er, and this rate is agreed at
the tim e of trade of the sw ap; the other party is the fl oating rate pay er,
the fl oating rate being determ ined du ring the life of the sw ap by
reference to a specifi c m ark et index . The principal or notional
am ou nt is nev er phy sically ex changed, hence the term ‘off
balance sheet’, bu t is u sed to calcu late interest pay m ents . The
fi x ed rate pay er receiv es fl oating rate interest and is said to be
‘long’ or to hav e ‘bou ght’ the sw ap. The long side has conceptu ally
pu rchased a fl oating rate note (becau s e it receiv es fl oating rate
interest) and issu ed a fi x ed cou pon bond (becau s e it pay s ou t fi x ed
interest at interv als) – that is, it has in principle borrow ed fu nds.
The fl oating rate pay er is said to be ‘short’ or to hav e ‘sold’ the sw ap.
The short side has conceptu ally pu rchased a cou pon bond (becau s e
it receiv es fi x ed rate interest) and issu ed a fl oating rate note (becau s e
it pay s fl oating rate interest).
So, an interest rate sw ap is
an agreement between two parties to exchange a stream of
cashflows calculated as a percentage of a notional sum and on
different interest bases.
For ex am ple, in a trade betw een Bank A and Bank B, Bank A m ay

agree to pay fi x ed sem i-annu al cou pons of 10% on a notional princi-
pal su m of £1 m illion, in retu rn for receiv ing from Bank B the
prev ailing 6-m onth sterling Libor rate on the sam e am ou nt. The
k now n cashfl ow is the fi x ed pay m ent of £50,000 ev ery 6 m onths
by Bank A to Bank B.
Lik e other fi nancial instru m ents , interest rate sw aps trade in a
secondary m ark et. The v alu e of a sw ap m ov es in line w ith
m ark et interest rates, in ex actly the sam e fashion as bonds . If a
5-y ear interest rate sw ap is transacted today at a rate of 5% and
5-y ear interest rates fall to 4.75% shortly thereafter, the sw ap w ill
hav e decreased in v alu e to the fi x ed rate pay er, and correspondingly
Table 4.2 Im pact of interest-rate changes
Fall in rates Rise in rates
Fix ed rate pay er Loss Profi t

Floating rate pay er Profi t Loss
increased in v alu e to the fl oating rate pay er, w ho has now seen the
lev el of interest pay m ents fall. The opposite w ou ld be tru e if 5-y ear
rates m ov ed to 5.25% . Why is this? Consider the fi x ed rate pay er in
an IR sw ap to be a borrow er of fu nds. If she fi x es the interest rate
pay able on a loan for 5 y ears and then this interest rate decreases
shortly afterw ards , is she better off? No, becau se she is now pay ing
abov e the m ark et rate for the fu nds borrow ed. For this reason a sw ap
contract decreases in v alu e to the fi x ed rate pay er if there is a fall in
rates. Equ ally , a fl oating rate pay er gains if there is a fall in rates, as he
can tak e adv antage of the new rates and pay a low er lev el of interest;
hence, the v alu e of a sw ap increases to the fl oating rate pay er if there
is a fall in rates.
The P&L profi le of a sw ap position is show n in Table 4.2.
Example of vanilla interest rate swap

The follow ing sw ap cashfl ow s are for a ‘pay fi x ed, receiv e fl oating’
interest rate sw ap w ith the follow ing term s:
Trade date 3 Decem ber 2010
Effectiv e date 7 Decem ber 2010
Matu rity date 7 Decem ber 2015
Interpolation m ethod Linear
Day -cou nt (fi x ed) Sem i-annu al, act/365
Day -cou nt (fl oating) Sem i-annu al, act/365
Nom inal am ou nt £10 m illion
Term 5 y ears
Fix ed rate 4.73%
The interest pay m ent dates of the sw ap fall on 7 Ju ne and
7 Decem ber; the cou pon dates of benchm ark gilts also fall on
these dates, so ev en thou gh the sw ap has been traded for con-
v entional dates, it is safe to su rm ise that it w as pu t on as a hedge
against a long gilt position. Fix ed rate pay m ents are not alw ay s the
sam e, becau se the actu al/365 basis w ill calcu late slightly different
am ou nts.
The sw ap w e hav e described is a plain v anilla sw ap, w hich m eans it
has one fi x ed rate and one fl oating rate leg. The fl oating interest rate
is set ju st before the relev ant interest period and is paid at the end of
the period. Note that both legs hav e identical interest dates and day -
cou nt bases, and the term to m atu rity of the sw ap is ex actly 5 y ears.
It is of cou rse possible to ask for a sw ap qu ote w here any of these
term s hav e been set to cu stom er requ irem ents ; for ex am ple, both
legs m ay be fl oating rate, or the notional principal m ay v ary du ring
the life of the sw ap. Non-v anilla interest rate sw aps are v ery
com m on, and bank s w ill readily price sw aps w here the term s
hav e been set to m eet specifi c requ irem ents. The m ost com m on
v ariations are different interest pay m ent dates for the fi x ed rate
leg and fl oating rate leg, on different day -cou nt bases, as w ell as
term s to m atu rity that are not w hole y ears.
Swap spreads and the swap yield curve

In the m ark et, bank s w ill qu ote tw o-w ay sw ap rates – on screens , on
the telephone or v ia a dealing sy stem su ch as Reu ters. Brok ers w ill
also be activ e in relay ing prices in the m ark et. The conv ention in the
m ark et is for the sw ap m ark et-m ak er to set the fl oating leg at Libor
and then qu ote the fi x ed rate that is pay able for that m atu rity . So, for
a 5-y ear sw ap a bank ’s sw ap desk m ight be w illing to qu ote the
follow ing:
Floating rate pay er: pay 6-m onth Libor
receiv e fi x ed rate of 5.19%
Fix ed rate pay er: pay fi x ed rate of 5.25%
receiv e 6-m onth Libor
In this case the bank is qu oting an offer rate of 5.25% , w hich the fi x ed
rate pay er w ill pay in retu rn for receiv ing Libor fl at. The bid price
qu ote is 5.19% w hich is w hat a fl oating rate pay er w ill receiv e fi x ed.
The bid–offer spread in this case is therefore 6 basis points. Fix ed rate
qu otes are alw ay s at a spread abov e the gov ernm ent bond y ield cu rv e.
Let u s assu m e that the 5-y ear gilt y ields 4.88% ; in this case, then, the
5-y ear sw ap bid rate is 31 basis points abov e this y ield. So, the bank ’s
sw ap trader cou ld qu ote sw ap rates as a spread abov e the benchm ark
bond y ield cu rv e, say 37-31, w hich is her sw ap spread qu ote. This
m eans that the bank is happy to enter into a sw ap pay ing fi x ed 31
Table 4.3 Sw ap qu otes.
1 y ear 4.50 4.45 17

2 y ear 4.69 4.62 25
3 y ear 4.88 4.80 23
4 y ear 5.15 5.05 29
5 y ear 5.25 5.19 31
10 y ear 5.50 5.40 35
basis points abov e the benchm ark y ield and receiv ing Libor, and
receiv ing fi x ed 37 basis points abov e the y ield cu rv e and pay ing
Libor. The bank ’s screen on, say , Bloom berg or Reu ters m ight
look som ething lik e Table 4.3, w hich qu otes sw ap rates as w ell as
the cu rrent spread ov er the gov ernm ent bond benchm ark .
A sw ap spread is a fu nction of the sam e factors that infl u ence the

spread ov er gov ernm ent bonds for other instru m ents . For shorter
du ration sw aps – say , u p to 3 y ears – there are other y ield cu rv es
that can be u sed in com parison, su ch as the cash m ark et cu rv e or a
cu rv e deriv ed from fu tu res prices. For longer dated sw aps the spread
is determ ined m ainly by the credit spreads that prev ail in the cor-
porate bond m ark et. Becau se a sw ap is v iew ed as a pack age of long
and short positions in fi x ed rate and fl oating rate bonds, it is the
credit spreads in these tw o m ark ets that w ill determ ine the sw ap
spread. This is logical; essentially , it is the prem iu m for greater
credit risk inv olv ed in lending to corporates that dictates that a
sw ap rate w ill be higher than sam e m atu rity gov ernm ent bond
y ield. Technical factors w ill be responsible for day -to-day fl u ctu a-
tions in sw ap rates, su ch as the su pply of corporate bonds and the
lev el of dem and for sw aps , plu s the cost to sw ap traders of hedging
their sw ap positions.
Overnight interest rate sw aps

An interest rate sw ap contract, w hich is generally regarded as a
capital m ark et instru m ent, is an agreem ent betw een tw o cou nter-
parties to ex change a fi x ed interest rate pay m ent in retu rn for a
fl oating interest rate pay m ent, calcu lated on a notional sw ap
am ou nt, at regu lar interv als du ring the life of the sw ap. A sw ap
m ay be v iew ed as being equ iv alent to a series of su ccessiv e FRA
contracts, w ith each FRA starting as the prev iou s one m atu res.
The basis of the fl oating interest rate is agreed as part of the
contract term s at the inception of the trade. Conv entional sw aps
index the fl oating interest rate to Libor; how ev er, an ex citing recent
dev elopm ent in the sterling m oney m ark et has been the sterling
ov ernight interest rate av erage or SONIA. In this section w e
rev iew SONIA sw aps , w hich are ex tensiv ely u sed by sterling
m ark et bank s.
SONIA is the av erage interest rate of interbank (u nsecu red) ov er-

night sterling deposit trades u ndertak en before 15:30 hou rs each day
betw een m em bers of the London Wholesale Money Brok ers’ Asso-
ciation. Recorded interest rates are w eighted by v olu m e. A SONIA
sw ap is a sw ap contract that ex changes a fi x ed interest rate (the sw ap
rate) against the geom etric av erage of ov ernight interest rates that
hav e been recorded du ring the life of the contract. Ex change of
interest tak es place on m atu rity of the sw ap. SONIA sw aps are
u sed to specu late on or to hedge against interest rates at the v ery
short end of the sterling y ield cu rv e; in other w ords, they can be u sed
to hedge an ex posu re to ov ernight interest rates.6 The sw aps them -
selv es are traded in m atu rities of 1 w eek to 1 y ear, althou gh 2-y ear
SONIA sw aps hav e also been traded.
Conv entional sw ap rates are calcu lated off the gov ernm ent bond
y ield cu rv e and represent the credit prem iu m ov er gov ernm ent
y ields of interbank defau lt risk . In essence, they represent av erage
forw ard rates deriv ed from the gov ernm ent spot (zero-cou pon) y ield
cu rv e. The fi x ed rate qu oted on a SONIA sw ap represents the av erage
lev el of ov ernight interest rates ex pected by m ark et participants ov er
the life of the sw ap. In practice, the rate is calcu lated as a fu nction of
the Bank of England’s repo rate. This is the 2-w eek rate at w hich the
Bank condu cts rev erse repo trades w ith bank ing cou nterparties as
part of its open m ark et operations. In other w ords, this is the Bank ’s
base rate. In theory , w e w ou ld ex pect the SONIA rate to follow the
repo rate fairly closely , since the credit risk on an ov ernight deposit is
low . How ev er, in practice, the spread betw een the SONIA rate and
the Bank repo rate is v ery v olatile, and for this reason the sw aps are
u sed to hedge ov ernight ex posu res.
Traditionally , ov ernight rates fl u ctu ate w idely du ring the day , depending
on the day ’s fu nds shortage, and althou gh v olatility has redu ced since the
introdu ction of gilt repo it is still u npredictable on occasion.
Example 4.9 Using an OIS sw ap to hedge a fu nding requ irem ent
A stru ctu red hedge fu nd deriv ativ es desk at an inv estm ent bank
offers a lev eraged inv estm ent produ ct to a client in the form of a
participating interest share in a fu nd of hedge fu nds. The client’s
inv estm ent is m ade u p partly of fu nds lent to it by the inv estm ent
bank , for w hich the interest rate charged is ov ernight Libor (plu s a
spread).
This inv estm ent produ ct has an ex pected life of at least 2 y ears.
As part of its rou tine asset–liability m anagem ent operations,
the bank ’s Treasu ry desk has been fu nding this requ irem ent by
borrow ing ov ernight each day . It now w ishes to m atch the fu nding
requ irem ent raised by this produ ct by m atching the asset term
stru ctu re to the liability term stru ctu re. Let u s assu m e that this
produ ct creates a USD1 billion fu nding requ irem ent for the bank .
Cu rrent m ark et depo rates are show n in Figu re 4.8. The Treasu ry
desk therefore fu nds this requ irem ent in the follow ing w ay :
Ass ets $1 billion, 1-y ear term
Receiv ing ov ernight Libor (plu s spread)
Liabilities $350 m illion, 6-m onth loan
Pay 1.22%
$350 m illion, 12-m onth loan
Pay 1.50%
$300 m illion, 15-m onth loan
Pay 1.70% (not show n in Figu re 4.8)
Figure 4.8 Illu stration of interest basis m is m atch hedging u sing

the OIS instru m ent.
Figure 4.9 Tu llet US dollar depo rates, 10 Nov em ber 2003.
This m atches the asset stru ctu re m ore closely to the term
stru ctu re of assets; how ev er, it opens u p an interest rate basis
m is m atch in that the bank is now receiv ing an ov ernight Libor-
based incom e bu t pay ing a term -based liability . To rem ov e this
basis m ism atch, the Treasu ry desk transacts an OIS sw ap to m atch
the am ou nt and term of each of the loan deals, pay ing ov ernight
fl oating rate interest and receiv ing fi x ed rate interest. The rates
for OIS sw aps of v ary ing term s are show n in Figu re 4.9, w hich
show s tw o-w ay prices for OIS sw aps u p to 2 y ears in m atu rity .
So, for the 6-m onth OIS the hedger is receiv ing fi x ed interest at a
rate of 1.085% and for the 12-m onth OIS he is receiv ing 1.40% .
The difference betw een w hat he is receiv ing in the sw ap and w hat
he is pay ing in term loans is the cost of rem ov ing the basis
m is m atch, bu t m ore fu ndam entally refl ects a k ey featu re of OIS
sw aps v ersu s deposit rates: depo rates are Libor-related, w hereas
US dollar OIS rates are driv en by the Fed Fu nds rate. On av erage,
the Fed Fu nds rate lies approx im ately 8–10 basis points below the
dollar deposit rate, and som etim es as m u ch as 15 basis points
below cash lev els.
Figure 4.10 Garban ICAP OIS rates for USD, 10 Nov em ber 2003.
This action hedges ou t the basis m ism atch and also enables the
Treasu ry desk to m atch its asset profi le w ith its liability
profi le. The net cost to the Treasu ry desk represents its hedging
costs.
Figu re 4.10 illu strates the transaction.
Example 4.9 Cashfl ow s on OIS
Table 4.4 show s daily rate fi x es on a 6-m onth OIS that w as traded
for an effectiv e date of 17 October 2003, at a fi x ed rate of 1.03% .
The sw ap notional is USD200 m illion.
From Table 4.4 w e see that the av erage rate for Fed Fu nds du ring
this period w as 0.99952% . Hence, on settlem ent the fi x ed rate
pay er w ou ld hav e passed ov er a net settlem ent am ou nt of
USD30,480.
Table 4.4 OIS cash fl ow s
Fix date Maturity Rate fix Fix date Maturity Rate fix
17/10/2003 20/10/2003 0.98 19/12/2003 22/12/2003 0.98

20/10/2003 21/10/2003 1.02 22/12/2003 23/12/2003 0.98
21/10/2003 22/10/2003 1.02 23/12/2003 24/12/2003 1.02
22/10/2003 23/10/2003 0.99 24/12/2003 26/12/2003 1
23/10/2003 24/10/2003 0.99 26/12/2003 29/12/2003 0.97
24/10/2003 27/10/2003 1.02 29/12/2003 30/12/2003 0.97
27/10/2003 28/10/2003 1.01 30/12/2003 31/12/2003 0.98
28/10/2003 29/10/2003 0.98 31/12/2003 02/01/2004 0.93
29/10/2003 30/10/2003 0.98 02/01/2004 05/01/2004 0.94
30/10/2003 31/10/2003 0.97 05/01/2004 06/01/2004 1.01
31/10/2003 03/11/2003 1.02 06/01/2004 07/01/2004 0.97
03/11/2003 04/11/2003 1.02 07/01/2004 08/01/2004 0.94
04/11/2003 05/11/2003 1.02 08/01/2004 09/01/2004 0.94
05/11/2003 06/11/2003 0.98 09/01/2004 12/01/2004 0.99
06/11/2003 07/11/2003 0.98 12/01/2004 13/01/2004 0.99
07/11/2003 10/11/2003 0.98 13/01/2004 14/01/2004 1
10/11/2003 12/11/2003 0.98 14/01/2004 15/01/2004 0.99
12/11/2003 13/11/2003 0.99 15/01/2004 16/01/2004 1.04
13/11/2003 14/11/2003 1 16/01/2004 20/01/2004 0.98
14/11/2003 17/11/2003 0.99 20/01/2004 21/01/2004 1.02
17/11/2003 18/11/2003 1.04 21/01/2004 22/01/2004 1
18/11/2003 19/11/2003 1.04 22/01/2004 23/01/2004 1.02
19/11/2003 20/11/2003 0.98 23/01/2004 26/01/2004 1
20/11/2003 21/11/2003 1 26/01/2004 27/01/2004 1
21/11/2003 24/11/2003 1 27/01/2004 28/01/2004 1.08
24/11/2003 25/11/2003 0.98 28/01/2004 29/01/2004 1.02
25/11/2003 26/11/2003 0.98 29/01/2004 30/01/2004 0.99
26/11/2003 28/11/2003 1.02 30/01/2004 02/02/2004 1.03
28/11/2003 01/12/2003 1.01 02/02/2004 03/02/2004 1.01
01/12/2003 02/12/2003 1.03 03/02/2004 04/02/2004 1.01
02/12/2003 03/12/2003 0.97 04/02/2004 05/02/2004 0.97
03/12/2003 04/12/2003 0.97 05/02/2004 06/02/2004 1
04/12/2003 05/12/2003 0.98 06/02/2004 09/02/2004 1.01
05/12/2003 08/12/2003 0.98 09/02/2004 10/02/2004 0.99
08/12/2003 09/12/2003 0.98 10/02/2004 11/02/2004 1
09/12/2003 10/12/2003 0.99 11/02/2004 12/02/2004 1
10/12/2003 11/12/2003 0.97 12/02/2004 13/02/2004 1.02
11/12/2003 12/12/2003 0.99 13/02/2004 17/02/2004 1.02
12/12/2003 15/12/2003 0.99 17/02/2004 18/02/2004 1.02
15/12/2003 16/12/2003 0.99 18/02/2004 19/02/2004 1
16/12/2003 17/12/2003 1.04 19/02/2004 20/02/2004 1
17/12/2003 18/12/2003 0.99 20/02/2004 23/02/2004 0.99
18/12/2003 19/12/2003 0.99 23/02/2004 24/02/2004 0.99
Fix date Maturity Rate fix Fix date Maturity Rate fix
24/02/2004 25/02/2004 1 23/03/2004 24/03/2004 1.01

25/02/2004 26/02/2004 0.99 24/03/2004 25/03/2004 0.99
26/02/2004 27/02/2004 1.02 25/03/2004 26/03/2004 0.99
27/02/2004 01/03/2004 1.04 26/03/2004 29/03/2004 1.02
01/03/2004 02/03/2004 1.04 29/03/2004 30/03/2004 1
02/03/2004 03/03/2004 1.04 30/03/2004 31/03/2004 1
03/03/2004 04/03/2004 1 31/03/2004 01/04/2004 0.98
04/03/2004 05/03/2004 0.99 01/04/2004 02/04/2004 1.05
05/03/2004 08/03/2004 0.99 02/04/2004 05/04/2004 1.03
08/03/2004 09/03/2004 1 05/04/2004 06/04/2004 1.01
09/03/2004 10/03/2004 0.99 06/04/2004 07/04/2004 1.01
10/03/2004 11/03/2004 0.99 07/04/2004 08/04/2004 1
11/03/2004 12/03/2004 1 08/04/2004 09/04/2004 1
12/03/2004 15/03/2004 0.99 09/04/2004 12/04/2004 1.02
15/03/2004 16/03/2004 1.05 12/04/2004 13/04/2004 1.01
16/03/2004 17/03/2004 1.05 13/04/2004 14/04/2004 1
17/03/2004 18/03/2004 1 14/04/2004 15/04/2004 1
18/03/2004 19/03/2004 1 15/04/2004 16/04/2004 1.01
19/03/2004 22/03/2004 0.99 16/04/2004 19/04/2004 0.99
22/03/2004 23/03/2004 1.01 Average rate 0.99952
CREDIT RISK HEDGING

The bu s iness of bank ing – lending m oney to and trading w ith
cou nterparties w ho carry defau lt risk – creates credit risk ex posu re
on the bank ’s balance sheet. This m u st be m anaged activ ely . In m any
cases, once a loan is originated, it cannot be rem ov ed from the
balance sheet, so the act of risk m anagem ent inv olv es raising the
capital base of the bank in anticipation of a deterioration in general
econom ic conditions. Equ ally , the bank m ight raise its loan origina-
tion standards, and redu ce the am ou nt it lends to borrow ers of low er
credit qu ality .
The other side of the approach to credit risk m anagem ent is to sell
loans w here possible, to rem ov e them from the balance sheet v ia
secu ritization or to u s e credit deriv ativ es. This topic is cov ered in
detail in Chou dhry (2007).
Understanding credit risk

Credit risk m anagem ent is a ju dgem ent call. The one single factor
that m ost assists effectiv e credit risk m anagem ent is k now ing one’s
m ark et. Unfam iliarity w ith a particu lar m ark et or cu stom er set, or
ov er-reliance on ‘black box ’ m odels to asses s loan origination
qu ality , ham pers the application of credit risk , becau se it renders
it su sceptible to the bu s iness cy cle. So, bey ond u nderstanding the
driv ers of credit risk and their dy nam ics, the ov er-riding principle
rem ains to u nderstand the m ark et w e are operating in. Nev er origin-
ate loans or inv est in assets that w e do not u nderstand. This principle
does not change irrespectiv e of the lev el of sophistication of the
produ ct or cu stom er. In other w ords, the com plex ity of a produ ct
or transaction does not alter the requ irem ent to u nderstand the
borrow er and its bu sines s risk s . That is w hat credit risk is. Ev en
w ith sophisticated transactions or com plex produ cts, w hile the
ev alu ation of the risk ex posu re m ay be m ore diffi cu lt, the need to
u nderstand the natu re of the risk does not alter. Ultim ately , the
qu estion of credit risk m anagem ent rem ains the sam e: What is
the chance that the inv estm ent w ill incu r losses, and how m u ch
w ill the lender lose if the borrow er is u nable to repay ? The answ er to
this qu estion, w hich is dy nam ic, gu ides the approach to bank credit
risk m anagem ent.
Definition of credit risk

Credit risk is the risk of loss du e to a ‘credit ev ent’. This w as the case
before the adv ent of the credit deriv ativ e m ark et w hich placed this
term into regu lar u sage. A credit ev ent can be a nu m ber of things ,
from ou tright defau lt du e to bank ru ptcy , liqu idation or adm inistra-
tion, or it can be som ething short of fu ll defau lt. It can also m ean loss
du e to credit m igration, su ch as a dow ngrade in credit rating. In the
credit deriv ativ es m ark et, the range of credit ev ents is defi ned in the
legal docu m entation gov erning the m ark et. In a fu ll defau lt, the
ex tent of loss can be observ ed im m ediately to be the fu ll notional
am ou nt of the loan; how ev er, ov er tim e, the lender w ill ty pically
receiv e an am ou nt of the loan back from the adm inistrators, k now n
as the ‘recov ery v alu e’. In a credit loss ev ent short of defau lt, the
am ou nt of loss is determ ined by apply ing m ark -to-m ark et (MtM)
v alu ation.
Defau lt itself is defi ned in m ore than one w ay . Generally , it is one or
m ore of the follow ing:
non-pay m ent of interest 90 day s after the interest du e date;

non-pay m ent of a loan 90 day s after the loan m atu rity date;
restru ctu ring of the borrow er’s loans;
fi ling for bank ru ptcy , the appointm ent of adm inistrators, liqu ida-
tion, and so on.
Late pay m ent is often term ed a non-perform ing loan (NPL) or a

delinqu ent loan rather than a defau lted loan if the borrow er is
still u ndertak ing bu sines s. How ev er, at som e point, irrespectiv e of
the state of the borrow er, an NPL w ill be w ritten off as a defau lt loss.
The w rite-dow n, w hich m u st be fu nded ou t of the bank ’s capital, is
often at 100% of ou tstanding notional v alu e, ev en thou gh the bank
w ill probably recov er a percentage, how ev er sm all, at som e later
date. Another defi nition of defau lt is that presented by Merton in
his 1974 paper. This states that defau lt occu rs w hen the v alu e of a
com pany falls below the v alu e of its debts. The defi nition of defau lt
is relev ant becau se for som e m odels it is a driv er of the calcu lation of
defau lt probability ; it is also relev ant to credit rating agencies w hen
they com pile the historical frequ ency of defau lt. Rating agencies
generally apply the delay -in-pay m ent defi nition.
Asset exposure
The notional, or absolu te, lev el of risk ex posu re is the fi rst port of
call. It is also the easiest to calcu late. It is giv en by the am ou nt of the
loan or inv estm ent w ith the cu stom er or ‘cou nterparty ’. 7 This
am ou nt m ay be fi x ed, som etim es called a ‘bu llet’ loan, or it m ay
redu ce steadily , w hich is an am ortising loan. If the ex posu re is a
v anilla loan that is recorded in the bank ’s balance sheet, the am ou nt
w ill not change from the origination date to the m atu rity date. If it is
a loan that is tradeable, su ch as a bond, or otherw ise su bject to MtM
v alu ation, then the ex posu re am ou nt w ill v ary according to its
v alu ation, bu t shou ld alw ay s be 100% of notional by the m atu rity
date. Figu re 4.11 is a sty lized representation of the behav iou r of asset
We hav e to be carefu l w ith the u se of the w ord ‘inv estm ent’. Here w e
m ean inv estm ent from the v iew point of the bank . In general conv ersation,
inv estm ent is often u sed to m ean an equ ity inv estm ent by a shareholder in
the bu siness. If a bank adv ances debt fu nds to a cu stom er, this is of cou rse
also an inv estm ent in the fu tu re w ellbeing of the com pany .
Figure 4.11 Notional v alu e risk ex posu re profi les of different

produ ct ty pes.
risk ex posu re by ty pe of asset, each of w hich has the sam e m atu rity
date.8
Trading book assets apply MtM. The v alu e of a loan that is u nder
MtM w ill change becau se of changes to the general lev el of interest
rates, and/or changes to the credit standing of the borrow er (or the
borrow er’s indu strial sector, or to credit conditions generally in the
m ark et). As su ch, trading book assets captu re changes in v alu e, at
least theoretically , that arise du e to, for instance, changes in credit
rating. This is k now n as credit m igration risk . The bank ing book ,
w hich does not apply MtM, cannot by defi nition captu re the m igra-
tion risk of its assets. It only captu res the risk of loss du e to defau lt.
This m ight be seen to be som e sort of disadv antage, becau se changes
in the credit standing of a borrow er also change its probability of
defau lt. How ev er, u se of MtM in a trading book is less of an adv an-
tage than w e m ight think , and in stressed m ark et conditions it can be
This is for illu stration. It is highly u ncom m on to observ e su ch a different

range of asset ty pes w ith identical m atu rity dates. Mortgage and project
fi nance loans hav e the longest legal fi nal m atu rity dates.
self-defeating (low er MtM v alu es can generate a v iciou s circle of

falling prices that im pacts confi dence and can itself lead to defau lt).
Ass et ex posu re on a balance sheet is not com prised solely of liv e
loans. It also inclu des potential fu tu re liabilities, su ch as letters of
credit, third-party liqu idity lines and other gu arantees. The notional
am ou nt of su ch off-balance-sheet ex posu res is also part of the bank ’s
credit risk ex posu re.
The m ain risk m anagem ent m echanism for asset ex posu re risk is by
m eans of credit lim its. This is the m ax im u m am ou nt that can be
ou tstanding at any tim e to the indiv idu al cu stom er, the indu strial
sector, the cou ntry , and so on. Lim its can also be set by cu rrency .
Credit rating rationale

Lenders and inv estors u se a credit rating, often alphanu m eric, to
describe the credit risk of an obligor. They represent, either im -
plicitly or ex plicitly , a defau lt probability of the borrow er ov er a
specifi ed tim e period. The ratings u sed can be those of an ex ternal
agency or those internal to the bank . The Basel II regu latory capital
m ethodology m ak es u se of either form al ex ternal ratings, in its
standardized approach, or of bank internal ratings, in its internal
ratings-bas ed approach.
The credit rating process for corporates applies a nu m ber of
qu alitativ e and qu antitativ e factors, w hich w e describe below . For
SPV-ty pe com panies a qu antitativ e approach can only be u sed, and
therefore is u sed. A bank ’s internal ratings sy stem u ses the sam e sort
of approach, m ak ing u se of defau lt probabilities and recov ery rates.
Bank internal credit ratings

All bank s em ploy som e form of internal credit rating m ethodology
for their cu stom ers. The rating criteria for bank internal sy stem s are
sim ilar in concept to those of ex ternal agencies; that is, they inclu de
qu alitativ e and qu antitativ e factors. Criteria are tw eak ed in accord-
ance w ith the ty pe of borrow er being asses sed. For ex am ple, fi nancial
institu tions w ill be asses sed by bank -specifi c m etrics su ch as the
loan-to-deposit ratio or the lev el of loan loss reserv es.
In recent y ears there has been a tendency for bank s to adopt a ‘black
box ’ approach, in w hich loan agents inpu t the requ ired param eters
into their sy stem and m odel ou tpu t either approv ed or disapprov ed

the loan. A redu ced lev el of hu m an ju dgem ent in the loan origination
process has lim itations that are ex posed du ring a recess ion or eco-
nom ic crash, m ainly becau se black box m odels are not im m u ne to
being su ck ed into a bu ll m ark et. For this reason, it is im portant that
the loan approv al process inclu des an elem ent of operator ju dgem ent,
w hich is of v alu e w hen the operator is fam iliar w ith the m ark et.
Internal ratings are sim ilar to ex ternal ones in assigning an alpha-

nu m eric grade to borrow ers that rank s their credit standing. For
m any bank s, the cu stom ers in qu estion w ill be sm all-and-
m ediu m -sized enterprises (SMEs) and so w ill not possess an ex ternal
agency credit rating. For SMEs it is m ainly the internal bank rating
that w ill driv e the loan approv al process. A bank ’s credit analy sis
departm ent w ill consider the obligor’s risk of defau lt, the credit
qu ality of any parent or su pporting com pany , the risk of the loan
produ ct itself and the back ing of any other bank ing institu tion w hen
calcu lating its internal rating. Assessm ent of the borrow er’s risk of
defau lt is sim ilar to the qu alitativ e and fi nancial rev iew u sed by
ex ternal agencies.
A bank operating across m ore than one legal ju risdiction w ill also
w ant to hav e an internal rating for each cou ntry . This is im portant
becau se, depending on the cou ntry concerned, it m ay be diffi cu lt or
im pos sible to recov er cash or assets in the ev ent of defau lt or to
enforce a legal ru ling. Therefore, a foreign cou ntry rating is requ ired
as w ell. This rem ains im portant ev en if the obligor is rated higher
than its dom icile cou ntry , becau se of the potential legal problem s
ju st noted.
The Basel II ru les cry stallized the u se of credit ratings by m ak ing

ex plicit reference to them in its standardized approach (see Chapter
10). How ev er, for m any bank s the standardized approach is no less
risk insensitiv e than Basel I, becau se their cu stom ers are not ex -
ternally rated. Su ch bank s can m ap ex ternal ratings to their internal
sy stem and assign risk w eights accordingly , prov iding they hav e
obtained regu lator approv al for their internal m odel. Generally ,
this m apping process inv olv es apply ing ex ternal ratings and their
im plied defau lt probabilities to the internal rating and obtaining an
ex ternal rating equ iv alent to the internal grade. This can be u nder-
tak en u sing an off-the-shelf credit m odel. Althou gh this process is in
com m on u se, it is inherently fl aw ed becau se of its reliance on the
tw o u su al param eters: defau lt probability and recov ery rate (RR).
Table 4.5 Moody ’s rating statistics 2007
Rating Yearly average default rate Yearly volatility of default rate

(1970–2007)
(% ) (% )
Aaa 0.00 0.00

Aa 0.05 0.12
A 0.08 0.05
Baa 0.20 0.29
Ba 1.80 1.40
B 8.30 5.03
Source: Moody ’s Inc., reprodu ced w ith perm ission.
The rating criteria refl ect the ‘ex pected loss’ (EL) of an asset, giv en by
EL Defau ltProb 1 RR
We see then that EL can alter signifi cantly by changing RR, ev en if

defau lt probability stay s u nchanged. This in tu rn can change the
ex ternal rating. Table 4.5 show s Moody ’s statistics for ratings and
defau lt, and the equ iv alent for each rating grade. It is possible to alter
a ratings-equ iv alent defau lt rate by changing the recov ery rate, and
thereby obtain a different rating. Bu s iness best practice and pru dent
risk m anagem ent dictate, therefore, that bank s assu m e a 0%
recov ery rate in their internal ratings sy stem s.
Credit lim it setting and rationale

For m any com m ercial bank s, and certainly all sm aller bank s, credit
lim its and credit ex posu re on a day -to-day basis are perhaps the
m ost im portant aspects of the risk m anagem ent process, giv en
that su ch institu tions shou ld not be ru nning m u ch m ark et risk .
The latter is m ore of an issu e for larger bank s, m u ltinational
bank s and m ark et-m ak ing bank s. While liqu idity risk m anagem ent
is u niv ersal to all bank s, m aintaining effectiv e credit risk origination
standards and a lim it-setting policy is essential for the v ast m ajority
of bank s that do not carry m aterial m ark et risk . Sm aller bank s are
less lik ely to be rescu ed by the central bank or the gov ernm ent if they
fail, becau se they w ou ld not be deem ed ‘sy stem ically im portant’, so
a pru dent credit risk m anagem ent cu ltu re and throu gh-the-cy cle
m acropru dential procedu res are of prim ary im portance for su ch

fi rm s. 9
We now discu s s the bu sines s best practice principles of credit lim it
setting and the loan origination process.
Credit process
Bank s generally operate one of tw o ty pes of approv al process: (i) v ia a
credit com m ittee or (ii) v ia delegated au thority from the credit
com m ittee to a bu sines s line head. The com m ittee process is de-
signed to ensu re that there is proper scru tiny of any transaction that
com m its the bank ’s capital. The sponsor bringing the transaction to
the com m ittee is the front offi ce bu sines s line; the com m ittee
w ill approv e or decline based on the risk –rew ard profi le of the
transaction.
Procedu re (ii) is com m on for high-v olu m e bu sines s, for w hich the
com m ittee process as a consequ ence of it being tim e consu m ing
w ou ld not be practical. As w e note abov e, there is u ncertainty
that the ‘k now y ou r risk ’ principle can be dilu ted, particu larly in
a com petitiv e env ironm ent w here a bank is try ing to bu ild v olu m e.
Giv en this u ncertainty , ‘m ark et share’ shou ld not be a perform ance
indicator, or target, for a bank ’s bu sines s line. Rather, perform ance
shou ld be m easu red only v ia the am ou nt of genu ine shareholder
v alu e added that the bu sines s generates.
Credit limit principles

The point of credit risk lim its is to set an u pper bou nd to the loss that
can be su ffered by a bank at any one tim e.
The basic principles of credit lim it setting are u niv ers al for ev ery
bank and follow the essential requ irem ents of pru dence and
concentration. In other w ords, an elem ent of div ersifi cation in the
In the US alone, according to the FDIC w ebsite, there w ere 25 bank

failu res in 2008, 140 in 2009 and 157 in 2010. This com pares w ith ju st 11
bank failu res du ring the period 2003–2007. With the ex ception of Washing-
ton Mu tu al Bank , these failing bank s did not m ak e the m edia headlines,
du e to their sm all size and dom estic bu siness base; nev ertheless, a failed
bank in any ju risdiction and of any size is a gross failu re of m anagem ent and
corporate gov ernance. Regu latory au thorities shou ld hav e the objectiv e
of treating all bank s as sy stem ically im portant.
loan portfolio is necessary , althou gh at all tim es the bank shou ld

practice the basic principle of ‘k now y ou r risk ’. In other w ords,
div ersity as an end in itself is not recom m ended good practice; a
bank shou ld div ersify only into sectors that it thorou ghly u nder-
stands and in w hich it has som e com petitiv e adv antage or v alu able
sk ill base.
In standard tex tbook s on fi nance and bank ing, w e read that it is the
capital base that driv es the lim it-setting process. Essentially , w hat
this is say ing in practice is that w e tak e the am ou nt of capital
av ailable and allocate it as per credit lim it bu ck ets for each of the
bu s inesses. Actu ally , the proper and intellectu ally robu st w ay to do
this is the other w ay arou nd: the bank shou ld determ ine its strategy
and bu sines s m odel, as w ell as preparing bu dgets based on the risk
ex posu re that it considers it has the ex pertise to m anage. This
process then driv es the lev el of capital and regu latory capital that
the bank shou ld then set u p. Once this am ou nt is k now n and
achiev ed, it can then be allocated to specifi c bu s iness lines as
low er lev el credit lim its by geography , indu stry , produ ct and so on.
The essential principles gov erning lim it setting inclu de the

follow ing:
All single ex posu res shou ld be su ffi c iently contained su ch that a

com plete defau lt, ru nning the risk of 0% recov ery , can be con-
tained w ithin the ex isting capital base and does not endanger the
bank as a going concern. In other w ords, after the loss the bank
shou ld still be w ithin its regu latory capital lim its.
The loan portfolio shou ld be div ersifi ed by indu strial sector,
geography and produ ct line, w ithin the k now ledge base and
ex pertise of the bank .
Set m inim u m internal (and, if desired, ex ternal) rating criteria
below w hich the bank w ill not lend. For ex am ple, this m ay be
‘inv estm ent grade rated only ’ or ‘no lending to entities w ith an
internal rating equ iv alent to BB/Ba2’.
Do not lend to obligors any am ou nt that as a resu lt ov erex tends
them and creates a situ ation in w hich repay m ent is pu t at risk .
This requ ires that the ‘k now y ou r risk ’ dictu m be applied equ ally
to u nderstanding the cu stom er’s risk s. This shou ld be asses sed
v ia an analy sis of the borrow er’s fi nancial indicators, inclu ding
lev erage ratio, debt serv ice cov erage ratio, and so on.
Set lim it categories to av oid concentration, and also by borrow er

rating.
As part of a transaction origination process, rev iew ers m u st consider
w hat ‘ancillary bu s iness’ can be generated from the sam e borrow er.
The bank m u st set a policy that dictates how m u ch this ancillary
bu s iness driv es the origination process, w hether the lending bu s i-
ness can be a ‘loss leader’ to an ex tent or can create su ffi cient
shareholder v alu e added in its ow n right.
Credit limit setting

The process of setting credit lim its is v ery im portant to all bank s –
v anilla com m ercial bank s, in particu lar – in so far as credit risk
ex posu re generates the highest losses for su ch institu tions. The
process shou ld follow pru dent and robu st policy and be ru n according
to cy cle-proof principles to av oid getting ov erex tended du ring a bu ll
m ark et, w hen loan origination standards are relax ed. Credit lim its
are set for a range of criteria, w hich are deliberately set as ov erlapping
so as to ensu re that all the v ariou s different categories of risk
ex posu re are captu red.
Macro-lev el credit lim its are set per indiv idu al obligor, originated
w ithin the bu sines s lines bu t approv ed by the Ex ecu tiv e Credit
Com m ittee and secondarily approv ed by ALCO. When necessary ,
if the size of a transaction dictates it, fu rther approv al m ay be needed
by the Ex ecu tiv e Managem ent Com m ittee (Ex Co) and the board
itself. The lev el of capital allocation requ ired for a particu lar lim it
application determ ines how far u p the gov ernance stru ctu re it needs
to go. Form al lim its on capital allocation are therefore set at Ex Co
approv al lev el.
The lim it-setting process is designed to produ ce ov erlapping lim its .
Lim its w ill be set in the follow ing categories:
Individual obligor. This is fu rther split into lim it by produ ct
class, lim it globally and lim it locally . Su b-lim its do not neces-
sarily aggregate to the ov erall obligor lim it: this is to prev ent
ex cess ex posu re in one produ ct class or geographical region.
Su b-lim its are also set per cu rrency . At all tim es, the obligor’s
ex posu re cannot ex ceed its ov erall lim it.
G eographical region. This is fu rther split into cou ntry lim its and
indiv idu al regions w ithin a cou ntry .
Industrial sector.
As no indiv idu al lim it can be breached, any new capital-u sing trans-
action m u st fi t into the capacity allow ed by all three lim it categories.
Lim it ex cess is a seriou s breach of m anagem ent gov ernance and
m u st be reported to ALCO (and, if necessary , Ex Co) for correctiv e
action. This can be one or m ore of the follow ing: (i) cease fu rther
bu s iness w ith the specifi c obligor; (ii) transfer som e of the ex posu re,
either by secondary m ark et sale, secu ritization, or hedging w ith
credit deriv ativ es; (iii) increase the lim it; (iv ) transfer som e capacity
from another part of the bu s iness and/or another obligor.
Loan origination process standards

The loan origination process differs across bank s. The detail of an
indiv idu al specifi c process is not of m ajor interest to u s. What is
im portant is that this origination process adheres to basic principles
of pru dence, and that these are controlled and m anaged to ensu re
they are ‘throu gh the cy cle’; that is, a redu ction in standards, or a
relax ation of them du ring a period of econom ic grow th, is som ething
that shou ld requ ire board approv al. Enlarging the balance sheet
du ring a bu ll m ark et is a risk y strategy , becau se it is du ring this
tim e that standards are low ered and low -qu ality and/or u nderpriced
assets are pu t on the book .
An ex am ple of this occu rred at the failed UK bank s Northern Rock
and Bradford & Bingley , w hich originated large nu m bers of 100LTV
and 125LTV m ortgages, as w ell as m ore risk y bu y -to-let m ortgages.
The failed bank HBOS (in com m on w ith m any bank s at the tim e)
operated a loan origination process for retail and corporate loans that
delegated the approv al decision to a black box com pu ter m odel,
w hich rated all applications in a tick box process that assigned a
credit score and then approv ed on that basis. This is u nderstandable
for high-v olu m e bu sines s m odels , bu t sacrifi ces a large elem ent of
‘k now y ou r cu stom er’ in the approv al process.
The essential gu idelines for a throu gh-the-cy cle asset origination
standards process inclu de:
Know your customer. For one-off and/or big-tick et transactions
this principle is straightforw ard to apply . It is m ore diffi cu lt for
large-v olu m e bu s iness, particu larly w hen the bank has adopted a
black box sy stem in w hich approv al is granted by a m odel (the
applicant’s details are inpu t to the sy stem and the sy stem gen-
erates the approv al w ithou t any loan offi cer or credit ex pert
rev iew ing the application). This is com m on practice for retail
bu sines s su ch as credit card and m ortgage applications, especially
for bu sines s condu cted ov er the telephone or internet. The danger
is that, in a com m oditized and com petitiv e m ark et, origination
standards are low ered and the bank creates a pool of low er qu ality
assets, the obligors for w hich it is not fam iliar w ith and w hose
fi nancial strength it cannot be certain of. This w as an acu te
problem for retail m ortgage bank s in the US, UK, Ireland and
Spain (am ongst others) du ring 2002–2007, all of w hom ex peri-
enced a hou s ing boom and bu st in this period. Bu s iness best
practice dictates that for all origination bu s iness, bank s m u st
k now their cu stom er base at all tim es (see below on m ortgages).
This m eans that the black box application process m u st be
su pplem ented w ith a rev iew by an ex perienced loan analy st.
Loan security. The collateral acceptable for a loan shou ld at all
tim es be of su ffi cient liqu idity and v alu e. The bank m u st be able
to realize the collateral if the obligor defau lts. Genu ine liqu idity
throu gh all m ark et conditions is restricted to sov ereign liabilities
only , so to cov er for the loss of liqu idity in other ty pes of col-
lateral, the bank m u st ensu re su ffi cient m argin ov er and abov e
the loan v alu e.
Subprime-lending restrictions. Assets against w hich no
collateral or insu ffi cient collateral is tak en shou ld at all tim es
be su bject to restrictions and sev ere lim its becau se these ty pes of
assets are the fi rst to ex perience defau lt w hen the econom y
ex periences a dow ntu rn. Mortgages that are not cov ered by
su ffi cient collateral, su ch as 100LTV or 125LTV loans w here
the adv ance is greater than the v alu e of the secu rity , and other
su bprim e m ortgages or higher risk m ortgages su ch as ‘self-
certifi ed’ loans shou ld sim ilarly be su bject to restriction.
Ex clu ding the peak of an ov erheating econom y ju st abou t to enter a

recess ion, loan defau lts ty pically do not occu r at the start or end of a
loan’s term . Another ex ception is right at the end of a bu ll m ark et,
w hen bank loan origination standards hav e been low ered and asset
prices (credit spreads) are at their m ost u nderv alu ed, w hen bank s
w rite m u ch low -qu ality bu sines s. Leav ing that aside, the m ost
com m on tim e of defau lt is generally betw een 45 and 55 m onths
after the loan start date. This m eans that defau lt statistics consider-
ably lag the actu al state of the econom y . Giv en historical defau lt
rates, w hich bank s u se to assist them in setting their credit lim its ,
there is a danger that bu s iness continu es to be w ritten at low er credit
standards at the tim e w hen the bank shou ld be reigning in risk y
bu s iness. This is w hy the basic principles w e su m m arize abov e

shou ld be observ ed at all tim es; they shou ld act as a gu iding light
for a bank ’s Ex ecu tiv e Credit Com m ittee.
BIBLIOGRAPHY
Chou dhry , M. (2007) Bank Asset and Liability Management, John Wiley
Asia.
Cox , J., Ingersoll, J., and Ross, S. (1981) ‘The relationship betw een forw ard
prices and fu tu res prices,’ Journal of Financial Economics, 9, Decem ber,
321–346.
Fabozzi, F. and Mann, S. (2001) Introduction to Fixed Income Analytics,
FJF Associates, Chapter 2.
French, K. (1983) ‘A com parison of fu tu res and forw ards prices,’ Journal of
Financial Economics, 12, Nov em ber, 311–342.
Hu ll, J. (1999) O ptions, Futures and O ther D erivatives, Fou rth Edition,
Prentice-Hall.
Jarrow , R. and Oldfi eld, G. (1981) ‘Forw ard contracts and fu tu res contracts,’
Journal of Financial Economics, 9, Decem ber, 373–382.
Kim ber, A. (2004) C redit Risk, Ox ford: Elsev ier.
Merton, R.C. (1974) ‘On the pricing of corporate debt: The risk stru ctu re of
interest rates,’ Journal of Finance, 29(2), May , 449–470.
Ru binstein, M. (1999) Rubinstein on D erivatives, RISK Pu blishing,
Chapter 2.
Windas, T. (1993) An Introduction to O ption-Adjusted Spread Analysis,
Bloom berg Pu blishing, Chapter 3
By Moorad Choudhry
Chapter
5
ASSET AND
LIABILITY
MANAGEMENT I
A sset–liability m anagem ent (ALM) is a generic term that is u sed

to refer to a nu m ber of things by different m ark et participants .
For bank ers, the term is u sed to denote high-lev el m anagem ent of a
bank ’s assets and liabilities; as su ch it is a strategy lev el discipline
bu t at the bu s iness line lev el it is also a tactical one. ALM policy
m ay be set w ithin a bank ’s Treasu ry div ision or m ore u su ally by its
asset–liability com m ittee (ALCO). The principle fu nction of
the ALM desk is to m anage interest rate risk and liqu idity risk .
It w ill also set ov erall policy for credit risk and credit risk m anage-
m ent, althou gh tactical lev el credit policy is set at a low er lev el
w ithin credit com m ittees. Althou gh the basic tenets of ALM
w ou ld seem to apply m ore to com m ercial bank ing than inv estm ent
bank ing, in reality it is im portant that it is applied to both fu nctions.
A trading desk still deals in assets and liabilities, and these m u st
be m anaged for interest rate risk and liqu idity risk . In a properly
integrated bank ing fu nction the ALM desk w ill hav e a rem it
cov ering all aspects of a bank ’s operations.
We describe the ALM fu nction in this chapter and Chapters 6 and 7.
In this chapter w e introdu ce the k ey ALM concepts of liqu idity and
ALM policy .
Basic concepts
In fi nancial m ark ets the tw o m ain strands of risk m anagem ent are
interest rate risk and liqu idity risk . ALM practice is concerned w ith
m anaging this risk . Interest rate risk ex ists in tw o strands . The fi rst
strand is the m ore obv iou s one: the risk of changes in asset–liability
v alu e du e to changes in interest rates. Su ch a change im pacts the
cashfl ow s of assets and liabilities as w ell as their present v alu e,
becau se fi nancial instru m ents are v alu ed w ith reference to m ark et
interest rates. The second strand is that associated w ith optionality ,
w hich arises w ith produ cts su ch as early -redeem able loans. The
other m ain ty pe of risk that ALM seek s to m anage is liqu idity
risk , w hich refers to both the liqu idity of m ark ets and the ease
w ith w hich assets can be translated to cash.
ALM is condu cted prim arily at an ov erv iew , balance sheet lev el. The
risk that is m anaged is an aggregate, grou p lev el risk . This m ak es
sense becau se one cou ld not m anage a v iable bank ing bu sines s by
leav ing interest rate and liqu idity risk m anagem ent at indiv idu al
operating lev els. We illu strate this at Figu re 5.1, w hich illu strates the
cornerstones of ALM. Essentially , interest rate risk ex posu re is
ASSET AND LIABILITY MANAGEMENT I 145
Figure 5.1 Cornerstone of ALM philos ophy .
m anaged at the grou p lev el by the Treasu ry desk . The driv ers are the
different cu rrency interest rates, w ith each ex posu re being m ade u p
of the net present v alu e (NPV) of cashfl ow as it changes w ith changes
in interest rates. The discou nt rate u sed to calcu late NPV is the
prev ailing m ark et rate for each tim e bu ck et in the term stru ctu re.
Interest rate ex posu re arises becau se rates fl u ctu ate from day to day ,
and continu ou sly ov er tim e. The prim ary risk is that of interest rate
reset for fl oating rate assets and liabilities. The secondary risk is
liqu idity risk : u nless assets and liabilities are m atched by am ou nt
and term , assets m u st be fu nded on a continu ou s rolling basis.
Equ ally , the receipt of fu nds m u st be placed on a continu ou s
basis. Whether an asset carries a fi x ed or fl oating rate reset w ill
determ ine its ex posu re to interest rate fl u ctu ations. Where an
asset is m ark ed at a fi x ed rate, a rise in rates w ill redu ce its NPV
and so redu ce its v alu e to the bank . This is intu itiv ely easy to grasp,
ev en w ithou t recou rse to fi nancial arithm etic, becau se w e can see
that the asset is now pay ing a below -m ark et rate of interest. Or w e
can think of it as a loss du e to opportu nity cost foregone, since the
assets are earning below w hat they cou ld earn if they w ere em ploy ed
elsew here in the m ark et. The opposite applies if there is a fall in
rates: this cau ses the NPV of the asset to rise. For assets m ark ed at a
fl oating rate of interest, the ex posu re to fl u ctu ating rates is m u ch
less , becau se the rate receiv able on the asset w ill reset at periodic
interv als, w hich w ill allow for changes in m ark et rates.
We speak of risk ex posu re as being for the grou p as a w hole. This
ex posu re m u st therefore aggregate the net risk of all the bank ’s
operating bu s iness. Ev en for the sim plest bank ing operation, w e
can see that this w ill produ ce a net m is m atch betw een assets and
liabilities, becau se different bu s iness lines w ill hav e differing objec-
tiv es for their indiv idu al book s . This m ism atch w ill m anifest itself
in tw o w ay s:
the m is m atch betw een the different term s of assets and liabilities
across the term stru ctu re;
the m ism atch betw een the different interest rates that each asset
or liability contract has been stru ck at.
This m is m atch is k now n as the ALM gap. The fi rst ty pe is referred to
as the liquidity gap, w hile the second is k now n as the interest rate
gap. We v alu e assets and liabilities at their NPV; hence, w e can
m easu re the ov erall sensitiv ity of balance sheet NPV to changes
in interest rates. As su ch, then, ALM is an art that encom pas ses
aggregate balance sheet risk m anagem ent at the grou p lev el.
Figu re 5.2 show s the aggregate grou p lev el ALM profi le for a
deriv ativ es trading hou s e based in London. There is a slight term
m is m atch as no assets are deem ed to hav e ‘ov ernight’ m atu rity
w hereas a signifi cant portion of fu nding (liabilities) is in the ov er-
night term . One thing w e do not k now from look ing at Figu re 5.2 is
how this particu lar institu tion defi nes the m atu rity of its assets. To
place them in the relev ant m atu rity bu ck ets, one can adopt one of
tw o approaches, nam ely :
actu al du ration of the assets;
‘liqu idity du ration’, w hich is the estim ated tim e it w ou ld tak e the
fi rm to dispose of its assets in an enforced or ‘fi resale’ situ ation,
su ch as a w ithdraw al from bu s iness.
Each approach has its adherents ; there is no single ‘right’ w ay . It is u p
to the indiv idu al institu tion to adopt one m ethod and then consis -
tently adhere to it. The second approach has the disadv antage,
Figure 5.2 A deriv ativ es trading hou se’s ALM profi le.
how ev er, of being inherently su bjectiv e – estim ating the tim e tak en
to dispose of an asset book is not an ex act science and is little m ore
than edu cated gu essw ork . Nev ertheless, for long-dated and/or illi-
qu id assets, it is at least a w ork able m ethod that enables practi-
tioners to w ork arou nd a specifi ed ALM fram ew ork w ith regard to
stru ctu ring the liability profi le.
Liquidity gap
There is clearly risk ex posu re as a resu lt of liqu idity m ism atches
betw een assets and liabilities. Matu rity term s w ill not m atch,
thereby creating a liqu idity gap. The am ou nt of assets and liabilities
m atu ring at any one tim e w ill also not m atch (althou gh ov erall, by
defi nition, assets m u st equ al liabilities). Liqu idity risk is the risk
that a bank w ill not be able to refi nanc e assets as liabilities becom e
du e, for any reason. 1 To m anage this, the bank w ill hold a large
portion of assets in v ery liqu id form . 2 A su rplu s of assets ov er
The reasons cou ld be m acro-lev el ones, affecting m ost or all m ark et

participants, or m ore fi rm specifi c or sector specifi c. The form er m ight be
a general m ark et correction that cau ses the su pply of fu nds to dry u p, and
w ou ld be a near-catastrophic situ ation. The latter is best illu strated w ith
the ex am ple of Barings plc in 1995: w hen it w ent bu st ov ernight du e to
large, hitherto concealed losses on the Sim ex ex change, the su pply of credit
to sim ilar institu tions w as redu ced or charged at m u ch higher rates – albeit
only tem porarily – as a resu lt.
Su ch assets w ou ld be v ery short-term , risk -free assets su ch as Treasu ry
bills.
liabilities creates a fu nding requ irem ent. If there is a su rplu s of

liabilities, the bank w ill need to fi nd effi cient u s es for these
fu nds. In either case, the bank has a liqu idity gap. This liqu idity
can be projected ov er tim e, so that one k now s w hat the situ ation is
each m orning, based on net ex piring assets and liabilities. The
projection w ill change daily , of cou rse, du e to the new bu sines s
u ndertak en each day .
We cou ld elim inate liqu idity gap risk by m atching assets and
liabilities across each tim e bu ck et. Actu ally , at the indiv idu al
loan lev el this is a popu lar strategy : if w e can inv est in an asset
pay ing 5.50% for 3 m onths and fu nd this w ith a 3-m onth loan
costing 5.00% , w e hav e lock ed in a 50 bp gain that is interest rate
risk free. How ev er, w hile su ch an approach can be u ndertak en at the
indiv idu al asset lev el, it w ou ld not be possible at the aggregate lev el,
or at least not possible w ithou t im posing sev ere restrictions on the
bu s iness. Hence, liqu idity risk is a k ey consideration in ALM. A
bank w ith a su rplu s of long-term assets ov er short-term liabilities
w ill hav e an ongoing requ irem ent to fu nd the assets continu ou sly ,
and there is the ev er-present risk that fu nds m ay not be av ailable as
and w hen they are requ ired. The concept of a fu tu re fu nding requ ire-
m ent is itself a driv er of interest rate risk , becau se the bank w ill not
k now the fu tu re interest rates at w hich it w ill deal.3 So a k ey part of
ALM inv olv es m anaging and hedging this forw ard liqu idity risk .
Definition and illustration

To reiterate then, the liqu idity gap is the difference in m atu rity
betw een assets and liabilities at each point along the term stru ctu re.
Becau se ALM in m any bank s concerns itself w ith m ediu m -term
m anagem ent of risk , this w ill not be bey ond a 5-y ear horizon – in
m any cases considerably less than this. Note from Figu re 5.2 how the
longest dated tim e bu ck et in the ALM profi le ex tended ou t to only
‘12 m onths ’, hence all liabilities longer than 1 y ear w ere grou ped in
one tim e bu ck et. This recognizes the fact that m ost liabilities are
shorter than 1 y ear, althou gh a proportion of fu nding w ill be longer
term – an av erage of 5 y ears or so.
For each point along the term stru ctu re at w hich a gap ex ists, there
is (liqu idity ) gap risk ex posu re. This is the risk that fu nds cannot
It can of cou rse lock in fu tu re fu nding rates w ith forw ard-starting loans,
w hich is one w ay to m anage liqu idity risk .
Figure 5.3 Com m ercial paper program m e liability profi le.
be raised as requ ired, or that the rate pay able on these fu nds is
prohibitiv e. 4 To m anage this risk , a bank m u st
disperse the fu nding profi le (the liability profi le) ov er m ore than
ju st a short period of tim e. For ex am ple, it w ou ld be ex cessiv ely
risk y to concentrate fu nding in ju st the ov ernight to 1-w eek tim e
bu ck et, so a bank w ill spread the profi le across a nu m ber of tim e
bu ck ets. Figu re 5.3 show s the liability profi le for a Eu ropean
m u lti-cu rrency asset-back ed com m ercial paper program m e,
w ith liabilities ex tending from 1 m onth to 1 y ear;
m anage ex pectations su ch that large-size fu nding requ irem ents
are diarized w ell in adv ance – not planned for tim es of low
liqu idity su ch as the Christm as and New Year period;
hold a signifi cant proportion of assets in the form of v ery liqu id
instru m ents su ch as v ery -short-term cash loans, Treasu ry
bills and high-qu ality short-term bank certifi cates of deposit
(CDs).
Follow ing these gu idelines leads to a reserv e of liqu idity that can be
tu rned into cash at v ery short notice in the ev ent of a fu nding crisis.
The size of the liqu idity gap at any one instant is nev er m ore than a
snapshot in tim e, becau se it is constantly changing as new com m it-
Of cou rse, the opposite applies w hen the gap risk refers to an ex cess of
liabilities ov er assets.
Table 5.1 Sim plifi ed ALM profi le for regional Eu ropean bank
12 m onths
9–12 m onth
1 m onth
3 m onth
6 m onth
1 w eek
Total
Assets 10 90 460 710 520 100 1,890
Liabilities 100 380 690 410 220 90 1,890
Gap 90 290 230 300 300 10
Marginal gap 200 60 530 0 290
m ents are entered into on both the asset and liability size. For this
reason som e w riters speak of a ‘static’ gap and a ‘dy nam ic’ gap, bu t in
practice one recognizes that there is only ev er a dy nam ic gap,
becau se the position changes daily . Hence, w e w ill refer only to a
liqu idity gap.
A fu rther defi nition is the ‘m arginal’ gap, w hich is the difference

betw een the change in assets and liabilities du ring a specifi ed tim e
period. This is also k now n as the ‘increm ental’ gap. If the change in
assets is greater than the change in liabilities, this is a positiv e
m arginal gap, w hile if the opposite applies it is a negativ e m arginal
gap.5
We illu strate these v alu es in Table 5.1. This is a sim plifi ed asset–
liability profi le from a regional Eu ropean bank , show ing gap and
m arginal gap at each tim e period. Note that liabilities hav e been
stru ctu red to produ ce an ‘ALM sm ile’, w hich is recognized as follow -
ing pru dent bu sines s practice. Generally , no m ore than 20% of total
fu nding shou ld be in the ov ernight to 1-w eek tim e bu ck et – sim ilarly
for the 9-to-12-m onth bu ck et. The m arginal gap is m easu red as the
difference betw een the change in assets and liabilities from one
period to the nex t.
Figu re 5.4 show s the graphical profi le of the nu m bers in Table 5.1.
Note that this term inology is not u niv ersally held.

Figure 5.4 ALM tim e profi le.
Liquidity risk
Liqu idity risk ex posu re arises from norm al bank ing operations.
That is, it ex ists irrespectiv e of the ty pe of fu nding gap, be it
ex cess assets ov er liabilities for any particu lar tim e bu ck et or an
ex cess of liabilities ov er assets. In other w ords, there is a fu nding
risk in any case: either fu nds m u st be obtained or su rplu s assets
laid off. The liqu idity risk in itself generates interest rate risk as a
resu lt of u ncertainty abou t fu tu re interest rates. This can be
m anaged throu gh interest rate hedging, w hich w as discu s sed in
Chapter 4.
If assets are fl oating rate, there is less concern ov er interest rate risk
becau se of the natu re of interest rate reset. This also applies to
fl oating rate liabilities, bu t only in so far as they m atch fl oating
rate assets. Floating rate liabilities issu ed to fu nd fi x ed rate assets
create forw ard risk ex posu re to rising interest rates. Note that ev en if
both assets and liabilities are fl oating rate, they can still generate
interest rate risk . For ex am ple, if assets pay 6-m onth Libor and
liabilities pay 3-m onth Libor, there is an interest rate spread risk
betw een the tw o term s. Su ch an arrangem ent has elim inated
liqu idity risk , bu t not interest rate spread risk .
Liqu idity risk can be m anaged by m atching assets and liabilities, or

by setting a series of rolling term loans to fu nd a long-dated asset.
Generally , how ev er, bank s hav e a particu lar v iew of fu tu re m ark et
conditions and m anage the ALM book in line w ith this v iew . This
w ou ld leav e in place a certain lev el of liqu idity risk .
Matched book
The sim plest w ay to m anage liqu idity and interest rate risk is the
m atched book approach, also k now n as cashflow matching. This is
actu ally v ery rare to observ e in practice, ev en am ong conserv ativ e
institu tions su ch as the sm aller UK bu ilding societies . In the
m atched book approach, assets and liabilities as w ell as their tim e
profi les are m atched as closely as possible. This inclu des allow ing for
am ortization of assets. 6 As w ell as m atching m atu rities and tim e
profi les, the interest rate basis for both assets and liabilities w ill be
m atched. That is, fi x ed loans to fu nd fi x ed rate assets and the sam e
for fl oating rate assets and liabilities. Floating rate instru m ents
w ill fu rther need to m atch the period of each interest rate reset to
elim inate spread risk .
Under a m atched book , there is theoretically no liqu idity gap.
Lock ing in term s and interest rate bases w ill also lock in profi t.
For instance, a 6-m onth fi x ed rate loan is fu nded by a 6-m onth
fi x ed rate deposit. This w ou ld elim inate both liqu idity and interest
rate risk . In a cu stom er-focu sed bu sines s it w ill not be possible to
precisely m atch assets and liabilities, bu t from a m acro-lev el it
shou ld be possible to m atch the profi les fairly closely , by netting
total ex posu re on both sides and m atching this. Of cou rse, it m ay not
be desirable to ru n a m atched book , as this w ou ld m ean the ALM
book w as not tak ing any v iew at all on the path of fu tu re interest
rates. Hence, a part of the book is u su ally left u nm atched, and this is
the part that w ill benefi t (or lose ou t) if rates go the w ay they are
ex pected (or not!).
Managing the gap with undated assets and liabilities

We hav e described a scenario of liqu idity m anagem ent w here the
m atu rity date of both assets and liabilities is k now n w ith certainty .
How ev er, a large part of retail and com m ercial bank ing operations
rev olv es arou nd assets that do not hav e an ex plicit m atu rity date.
Thes e inclu de cu rrent accou nt ov erdrafts and credit card balances .
They also inclu de draw n and u ndraw n lines of credit. The v olu m e of
these is a fu nction of general econom ic conditions, and can be
diffi cu lt to predict. Bank s w ill need to be fam iliar w ith their
Many bank assets, su ch as residential m ortgages and credit card loans, are
repaid before their legal m atu rity date. Thu s, the size of the asset book is
constantly am ortizing.
clients’ behav iou r and their requ irem ents ov er tim e to be able to
asses s w hen and for how long these assets w ill be u tilized.
Undated assets are balanced on the other side by u ndated liabilities,
su ch as non-interest-bearing liabilities (NIBLs) w hich inclu de
chequ e accou nts and instant access deposit accou nts. The latter
frequ ently attract v ery low rates of interest – hence, they can be
inclu ded in the NIBL total. Undated liabilities are treated in different
w ay s by bank s; the m ost com m on treatm ent places these fu nds in
the shortes t tim e bu ck et, the ov ernight to 1-w eek bu ck et. How ev er,
this m eans a bank ’s gap and liqu idity profi le can be highly v olatile
and u npredictable, w hich places greater strain on ALM m anage-
m ent. For this reason som e bank s tak e the opposite approach and
place these fu nds in the longest dated bu ck et, the 12-m onth
bu ck et. A third approach is to split total u ndated liabilities into a
‘core’ balance and an ‘u nstable’ balance, and place the fi rst in the
long-date bu ck et and the second in the shortes t dated bu ck et. The
am ou nt recognized as the core balance w ill need to be analy sed ov er
tim e to m ak e su re it is accu rate.
Managing liquidity
Managing liqu idity gaps and the liqu idity process is both continu ou s
and dy nam ic becau se the ALM profi le of a bank changes on a daily
basis. Liqu idity m anagem ent is the term u sed to describe this con-
tinu ou s process of raising and lay ing off fu nds, depending on w hether
one is long or short cash that day .
The basis prem ise is a sim ple one: the bank m u st be ‘squ ared off ’ by
the end of each day , w hich m eans ensu ring the net cash position is
zero. Thu s, liqu idity m anagem ent is both v ery short term as w ell as
projected ov er the long term , becau se ev ery position pu t on today
creates a fu nding requ irem ent in the fu tu re on its m atu rity date.
The ALM desk m u st be aw are of its fu tu re fu nding or ex cess cash
positions and act accordingly , w hether this m eans raising fu nds now
or hedging forw ard interest rate risk .
The basic case: the funding gap

A fu nding requ irem ent is dealt w ith on the day it occu rs. The
decision on how it w ill be treated w ill factor the term that is pu t
on – it has also to allow for any new assets pu t on that day . As fu nding
is arranged, the gap on that day w ill be zero. The nex t day there w ill
Figure 5.5 Fu nding position on a daily basis.
be a new fu nding requ irem ent or a su rplu s depending on the net

position of the book .
This is illu strated in Figu re 5.5. Starting from a fl at position on

the fi rst day (t0 ) w e observ e a gap (the dotted line) on t1 w hich is
closed by pu tting on fu nding to m atch the asset m atu rity . The
am ou nt of fu nding to raise and the term for it to ru n w ill tak e
into accou nt the fu tu re gap as w ell as that day ’s bank ing activ ities.
So, at t2 w e observ e a fu nding ex cess, w hich is then laid off. We see at
t3 that inv ested assets ru n bey ond the m atu rity of the liabilities at t2 ,
so w e hav e a fu nding requ irem ent again at t3 . The decision on the
term and am ou nt w ill be based on the m ark et v iew of the ALM desk .
A m atched book approach m ay w ell be tak en w here the desk does not
hav e a strong v iew or if its v iew is at odds w ith m ark et consensu s.
There are also ex ternal factors to tak e into accou nt. For instance, the
av ailability of fu nds in the m ark et m ay be lim ited, du e to both
m acro-lev el issu es and to the bank ’s ow n ability to raise fu nds.
The form er m ight be du ring tim es of m ark et correction or recess ion
(a ‘credit cru nch’), w hile the latter m ight inclu de the bank ’s credit
lines w ith m ark et cou nterparties. Moreov er, som e fu nds w ill hav e
been raised in the capital m ark ets and this cash w ill cov er part of the
fu nding requ irem ent. In addition, the ALM desk m u st consider the
cost of the fu nds it is borrow ing – for ex am ple, if it thou ght that
interest rates in the short term , or for short-term periods, w as going
to fall, it m ight cov er the gap w ith only short-term fu nds so that it
can then refi nance at ex pected low er rates. The opposite m ight be
done if the desk thou ght rates w ou ld rise in the near fu tu re.
Ru nning a liqu idity gap ov er tim e, bey ond cu stom er requ irem ents ,
w ou ld refl ect a particu lar v iew of the ALM desk . So, m aintaining a
consistently u nderfu nded position su ggests that interest rates are
ex pected to decline, and so longer term fu nds can be tak en at cost.
Maintaining an ov erfu nded gap w ou ld im ply that the bank think s
rates w ill be rising, and so longer term fu nds are lock ed in now at
low er interest rates. Ev en if the net position is dictated by cu stom er
requ irem ents – for ex am ple, cu stom ers placing m ore on deposit than
they tak e ou t in loans – the bank can still m anage the resu ltant gap in
the w holesale m ark et.
Generally , ex cess liabilities at a bank are a rare occu rrence and,
u nder m ost circu m stances , su ch a position is clearly u ndesirable.
This is becau se the bank w ill hav e to achiev e target retu rn on capital
ratios, and this requ ires fu nds to be pu t to w ork , so to speak , by
acqu iring assets. In the case of equ ity capital it is im perativ e that
these fu nds are properly em ploy ed. 7 The ex act stru ctu re of the asset
book w ill depend on the bank ’s v iew on interest rates and the y ield
cu rv e generally . The shape of the y ield cu rv e and ex pectations on
this w ill also infl u ence the stru ctu re and tenor of the asset book . The
com m on practice is to spread assets across the term stru ctu re, w ith
v ary ing m atu rities. There w ill also be inv estm ents m ade w ith a
forw ard start date, to lock in rates in the forw ard cu rv e now .
Equ ally , som e inv estm ents w ill be m ade for v ery short periods so
that if interest rates rise, w hen the fu nds are reinv ested they w ill
benefi t from the higher rates.
The basic case: illustration

The basic case is illu strated in Table 5.2 in tw o scenarios. In the fi rst
scenario, the longest dated gap is 130, so the bank pu ts on fu nding
for 130 to m atch this tenor of three periods. The gap at period t2 is
410, so this is m atched w ith a tw o-period tenor-fu nding position of
280. This leav es a gap of 180 at period t1 w hich is then fu nded
w ith a single-period loan. The net position is zero at each period
(‘squ ared off ’), and the book has been fu nded by three bu llet fi x ed-
The bank ’s capital w ill be inv ested in risk -free assets su ch as gov ernm ent
T-bills or, in som e cases, bank CDs. It w ill not be lent ou t in norm al
bank ing operations becau se the ALM desk w ill not w ant to pu t capital in a
credit-risk y inv estm ent.
Table 5.2 Fu nding the liqu idity gap: tw o ex am ples
Tim e
Scenario (i)
Assets 970 840 1,250
Liabilities 380 430 1,120
Gap 590 410 130
Borrow 1: three-period tenor 130 130 130
Borrow 2: tw o-period tenor 280 280
Borrow 3: single-period tenor 180
Total fu nding 590 410 130
Squ ared off 0 0 0
Scenario (ii)
Assets 970 840 1,250
Liabilities 720 200 1,200
Gap 250 640 50
Borrow 1: three-period tenor 50 50 130
Borrow 2: tw o-period tenor 200 200
Borrow 3: single-period tenor 0 390
Total fu nding 250 640 50
Squ ared off 0 0 0
term loans. The position is not a m atched book as su ch althou gh

there is now no liqu idity risk ex posu re.
In the second case, the gap increases from Period 1 to Period 2.
The fi rst period is fu nded by a three-period and a tw o-period
borrow of 50 and 200, respectiv ely . The gap at t2 needs to be
fu nded by a position that is not needed now. The bank can cov er
this w ith a forw ard start loan of 390 at t1 or can w ait and act at t2 .
If it does the latter it m ay still w is h to hedge the interest rate
ex posu re. 8
The liquidity ratio

The liquidity ratio is the ratio of assets to liabilities. It is a short-term
ratio that is u p to 1 y ear, u s u ally calcu lated for the m oney m ark et
We look at the m echanics of this, u sing different deriv ativ e instru m ents,
in Chapter 4.
term only . Under m ost circu m stances , and certainly u nder a positiv e
y ield cu rv e env ironm ent, it w ou ld be ex pected to be abov e 1.00;
how ev er, this is less com m on at the v ery short end becau se the
av erage tenor of assets is often greater than the av erage tenor of
liabilities. So, in the 1-m onth to 3-m onth tenor period – and
perhaps ou t to the 6-m onth tenor – the ratio m ay w ell be less
than 1. This refl ects the fact that short-term borrow ing is u sed to
fu nd longer term assets.
A ratio signifi cantly below 1 is ineffi cient from an ROE point of v iew .
It represents an opportu nity cost of retu rn foregone. To m anage it,
bank s m ay inv est m ore fu nds in the v ery short term , bu t this also
presents its ow n problem s becau se retu rn on these assets m ay not be
su ffi cient. This is especially tru e in a positiv e y ield cu rv e env iron-
m ent. This is one scenario w here a m atched book approach w ill be
pru dent, becau se the bank shou ld be able to lock in a bid–offer spread
at the v ery short end of the y ield cu rv e. 9 A m ore risk y approach
w ou ld be to lend in the short term and fu nd them in the long term ,
bu t this w ou ld create problem s becau se the term prem iu m in the
y ield cu rv e w ill m ak e borrow ing in the long term ex pensiv e relativ e
to the retu rn on short-dated assets (u nless w e hav e an inv erted y ield
cu rv e). There is also the liqu idity risk associated w ith the m ore
frequ ent rolling ov er of assets than liabilities. We see then, that
m aintaining the liqu idity ratio carries som ething of a cost for bank s.
The liquidity portfolio

The basic bu sines s of bank ing is maturity transformation; this is the
practice of lending long-dated assets that are fu nded by shorter dated
liabilities. This is to be ex pected: a bank that lends 25-y ear m oney to
a cu stom er in the form of a retail m ortgage w ou ld not ex pect and,
indeed w ou ld not aim , to fu nd the asset w ith a borrow ing of 25-y ear
m oney . The bu sines s of bank ing assu m es therefore the av ailability
of continu ou s fu nding capability , or liqu idity . To prov ide risk m iti-
gation for the tim es w hen liqu idity conditions deteriorate – the tim e
period after the bank ru ptcy of Lehm an Brothers in Septem ber 2008 is
the best ex am ple – bank s m aintain a portfolio of liqu id assets. This is
In addition, the bank shou ld be able to raise fu nds at Libor, w hile it shou ld
be able to lend at Libor plu s a spread in short-dated interbank credit qu ality
assets.
som etim es k now n as the ‘liqu id asset bu ffer’ and is ty pically m ade
u p of AAA-rated gov ernm ent bonds .
Prior to the Lehm an collapse, som e bank s had stopped follow ing
m ark et best practice and had ceased to m aintain a liqu id portfolio of
gov ernm ent bonds (w hich, being credit-risk -free assets, pay the
low est RoC), or had constru cted the liqu id portfolio ou t of bank -
issu ed certifi cates of deposit (CDs) and fl oating rate notes (FRNs).
How ev er, these assets w ere show n to su ffer from poor liqu idity
u nder the m ark et crisis conditions that prev ailed betw een
October and Decem ber 2008, so bu sines s best practice philosophy
has since changed and bank s now m aintain a gov ernm ent bond
liqu idity portfolio.
Example 5.1 Hy pothetical bank (XYZ Secu rities) sov ereign bond
portfolio for repo and interest rate hedging
The Treasu ry desk m aintains a liqu idity book of US Treasu ry ,

Germ an bu nd and UK gilts. This is also u sed to facilitate a repo
bu s iness and redu ce the qu antity of interest rate fu tu res needed as
part of the interest rate ex posu re hedge.
Description of the product/business activity

XYZ’s Treasu ry desk is requ ired to fu nd a large part of the
fi rm -w ide fu nding requ irem ent in term loans, as part of pru dent
asset–liability m anagem ent. The resu lting DV01 (dollar-v alu e of
loss for a 1 bp rise in y ields) ex posu re is m anaged u sing Eu rodollar
fu tu res. It has also established a US gov ernm ent bond portfolio as a
low er cost m eans of m anaging DV01 risk . The objectiv e is to
m anage the DV01 ex posu re of the Treasu ry book by bu y ing v ery
short-dated Treasu ry notes and strips, w hich sets u p an incom e
stream that is div ersifi ed from other sou rces and that represents
zero credit risk . This is achiev ed by
Establishing a portfolio of v ery -short-dated US Treasu ries and
Treasu ry strips on the balance sheet (m ax im u m m atu rity
recom m ended 1–1.5 y ears, the m ajority in 3 to 6 m onths).
The com position of the book at May 2005 is
200 m illion 3 m onth
300 m illion 6 m onth
50 m illion 1 y ear.
the av erage m atu rity of the portfolio in the fi rst y ear is to be
arou nd 6 m onths.
Fu nding these in Treasu ry repo u nder the standard GMRA. 10

Holding Treasu ry secu rities and Treasu ry strips to m atu rity to
generate a steady incom e stream . With u ltra-short-dated strips,
this also benefi ts from the pu ll-to-par effect on m ark to
m ark et.
All fu nding is lock ed in to m atu rity , thu s there is no gap risk .
Objectives of the business

The sov ereign bond book is bu s iness that
allow s XYZ to u ndertak e cheaper hedging of its interest rate
risk (DV01), com plem enting the cu rrent arrangem ent u sing
Eu rodollar and 90-day m oney fu tu res;
establishes a risk -free portfolio that generates a fu nding gain
for XYZ;
enables XYZ to u se a AAA risk -free portfolio for u se in setting
u p total retu rn sw ap (TRS) and repo lines w ith m ark et
cou nterparties.
The benefi ts to XYZ of holding su ch a portfolio inclu de
earning the spread betw een y ield and fu nding cost; a bonu s
that is not av ailable w hen u sing Eu rodollar fu tu res for DV01
hedging, w hich do not earn any incom e. XYZ also sav es on the
com m ission and m argin costs associated w ith m aintaining
Eu rodollar fu tu res positions;
u sing the bu sines s to set u p dealing relationships w ith bank
cou nterparties that cou ld then be u sed as sou rces of additional
fu nding if requ ired, adding to the div ersity of fu nding (requ ired
as part of the Treasu ry desk ’s rem it);
assisting the Treasu ry desk in u ndertak ing ALM objectiv es
throu gh low er cost hedging of DV01 risk , com pared w ith
fu tu res w hich im pos e a cost on the book .
Expected return
The fu ndam ental gain is rem ov al of the requ irem ent to hold
Eu rodollar fu tu res. In a rising interest rate env ironm ent, this
w ill signifi cantly redu ce hedging costs.
See Chapter 2.
Net profi t in the fi rst fu ll y ear is u pw ards of a $250,000–$280,000

fu nding gain on a £350 m illion av erage position (10–12 bp on
av erage per trade). This does not tak e into accou nt the m ark -to-
m ark et profi t that is realized on Treasu ry bonds and strips.
Capital and taxation issues

Treasu ry secu rities are 0% risk -w eighted u nder Basel I (and II),
ex cept w here they create DV01 risk w hen the charge is 0.7% .
How ev er, if held for interest-rate-ris k -hedging pu rposes (as is the
case here), they m ay actu ally redu ce ov erall capital requ irem ents .
Example 5.2 XYZ Secu rities’ sov ereign bond portfolio for
interest rate hedging: no lending bu sines s
This illu stration m irrors that of Ex am ple 5.1, ex cept w e assu m e

that the fi rm (XYZ Secu rities) has no lending operation. That is, its
Treasu ry desk is not a tru e m oney m ark et desk becau se it is only a
borrow er of fu nds; there is no lending of fu nds. In this case, the
fi rm sets u p a sov ereign bond portfolio to redu ce its risk -hedging
costs. The follow ing are real-w orld ex am ples of tw o su ch port-
folios of US Treasu ries and UK gilts, u sed to hedge their USD and
GBP term -fu nding book s .
Background
As part of its k ey bu s iness fu nction, XYZ Secu rities’ Treasu ry
fu nction m aintains a large short cash position. It is not able to tak e
the other side in the m ark et, w hich w ou ld giv e it added fl ex ibility
in its dealing arrangem ents and ALM m anagem ent, as w ell as
m ore effi cient m echanism s for interest rate risk hedging. This also
m eans the Treasu ry desk is restricted in bu ilding cou nterparty
relationships and fu nding sou rce div ersity .
In look ing to div ersify its bu sines s m ix – to achiev e cheaper
interest rate risk m anagem ent and a m ore activ e ALM approach –
it m aintains a portfolio of v ery short-dated US Treasu ry secu rities
and Treasu ry strip (zero-cou pon) bonds , fu nded in repo. This w ou ld
be held to
establish a risk -free portfolio that generates fu nding gain;
allow cheaper hedging of interest rate risk (DV01) than an

arrangem ent that u ses Eu rodollar fu tu res;
enables XYZ to u se a AAA risk -free portfolio for u se in setting
u p TRS and repo lines w ith m ark et cou nterparties.
The benefi ts to XYZ of holding su ch a portfolio inclu de
earning the spread betw een y ield and fu nding cost; a bonu s
that is not av ailable w hen u sing Eu rodollar fu tu res for DV01
hedging, w hich do not earn any incom e;
cou nterparties w hich cou ld then be u sed as sou rces of addi-
tional fu nding if requ ired, adding to the div ersity of fu nding
(requ ired as part of the Treasu ry desk ’s rem it);
assisting the Treasu ry desk to u ndertak e ALM objectiv es
throu gh low er cost hedging of DV01 risk , com pared w ith
fu tu res w hich im pos e a cost on the book .
All fu nding w ill be lock ed in to m atu rity , thu s there is no gap
risk .
Profitable risk-free trade example undertaken on 1 July 2004

Below are ex am ples of fu nding trades that w ere pu t on in Ju ly 2004
that generated a risk -free fu nding gain – rates as at 1 Ju ly 2004 (data
sou rce: Lehm an Brothers and Bloom berg LP). This show s w here
v alu e w as obtained from holding a book of Treasu ries in the fi rst
instance. The follow ing positions all y ielded fu nding profi t:
Bu y the 2% Nov em ber 2004 Treasu ry at a y ield of 1.597% and

hold to m atu rity , and repo to m atu rity at a rate of 1.56% . This
giv es a lock ed-in gain of 3.97 bp for the term to m atu rity on a
position of USD150 m illion at a profi t of USD24,800.
Bu y the 31 Ju ly 2004 strip at a y ield of 1.568% and repo to
m atu rity at 1.28% . This giv es a spread of 28.8 bp of risk -free
lock ed-in fu nding. On a position of USD200 m illion this
represents a positiv e P&L of USD48,000 – this is risk -free
incom e.
Tak e adv antage of special rates for stock s w e are long in. On
1 Ju ly , a position in 1 % May 2005 Treasu ry cou ld be fu nded
cheaper than norm al repo (general collateral or GC) by 7–8 bp
as a resu lt of its special statu s . So the gain on holding that
stock w ou ld be arou nd this am ou nt for the term of the trade,
as ou r fu nding cost in repo w ou ld be low er by this am ou nt.
It w ou ld be an objectiv e of the Treasu ry desk to be aw are of

stock s ex pected to go special and act accordingly .
Despite their infrequ ency these opportu nities do occu r as show n

abov e. As the book w ill be prim arily designed to hedge, trading is
infrequ ent and only u ndertak en as opportu nities arise.
Risks
There is no gap (fu nding) risk and no credit risk .
Ju st lik e the positions on a trading book – rather than a bank ing
book – they w ill be m ark ed-to-m ark et. The desk ex pects v olatility
in short-dated gov ernm ent bonds to be low er than for the term
loans they are hedging, bu t v olatility is a risk ex posu re and there
m ay be periods w hen the desk w ill ex perience m ark -to-m ark et
losses.
Example 5.3 UK gilt portfolio
Com m ercial bank s and bu ilding societies are natu ral holders of
gov ernm ent bonds su ch as gilts. They do so for the follow ing
reasons :
becau se gilts are the m ost liqu id instru m ents in the UK
m ark et;
as an instru m ent in w hich to inv est the fi rm ’ s capital reserv es;
for incom e generation pu rposes, giv en the fav ou rable fu nding
costs of gilt repo as w ell as zero credit and liqu idity risk ;
to interm ediate betw een gilt, stock loans and interbank
m ark ets in CDs;
to benefi t from being long in gilts that go special and can be
fu nded at any thing from 25 bp to 2% to 3% cheaper than GC
repo;
to establish an asset pool that receiv es fav ou rable capital
treatm ent (0% risk -w eighted u nder Basel I and Basel II);
The benefi ts to XYZ of holding su ch a portfolio inclu de som e of the
abov e, as w ell as the follow ing:
earning the spread betw een y ield and fu nding cost;
cou nterparties that cou ld then be u sed as sou rces of additional
fu nding if requ ired, adding to the div ersity of fu nding (requ ired
as part of the Treasu ry desk ’s rem it);
assisting the Treasu ry desk in u ndertak ing ALM objectiv es.
Business line
A UK gov ernm ent bond portfolio at XYZ’s Treasu ry desk has the
objectiv e of m aintaining an incom e stream that is div ersifi ed from
cu rrent sou rces and that is also relativ ely low risk , bu t stable. This
is achiev ed by
Establishing a portfolio of v ery short-dated gilts and gilt
strips on the balance sheet (m ax im u m m atu rity recom m ended
1 y ear, the m ajority in 3 to 6 m onths). The ex pected m ak eu p of
the book m ight be
125 m illion 3 m onths
200 m illion 6 m onths
25 m illion 1 y ear
the av erage m atu rity of the portfolio in the fi rst y ear w ou ld
be arou nd 6 m onths.
Fu nding these in gilt repo – u nder the GMRA agreem ent – and
fu nding u sing TRS – u nder ISDA – if requ ired. The repo-
fu nding m argin for gilts in the w holesale m ark et is often 0% .
With a zero or v ery low m argin – that is, a haircu t – all
positions w ill be v irtu ally fu lly fu nded.
Holding gilts and gilt strips to m atu rity to generate a steady
incom e stream . With u ltra-short-dated strips, w e also benefi t
from the pu ll-to-par effect.
Market rates
Table 5.3 show s incom e y ields and fu nding rates as at 2 Ju ne 2004.
This show s w here v alu e w as obtained from holding a book of gilts
in the fi rst instance. For ex am ple, all the follow ing positions
y ielded fu nding profi t:
Hold gilts and fu nd in GC; depending on the specifi c stock
and the term of fu nding arranged, a gain ranging from 15 bp to
50–60 bp.
Hold strips to m atu rity . For ex am ple, a gain of approx im ately
35 bp for a Dec 04 principal strip at 1-w eek or 2-w eek fu nding;
and a lock ed-in fu nding gain of 9 bp for a Dec 04 strip (bu y a
6-m onth strip and fu nd in 6 m onths) – this is risk -free incom e.
Table 5.3 Mark et rates as at 2 Ju ne 2004
GC rates
1w 4.15 4.10
2w 4.25 4.15
3w 4.25 4.15
1m 4.25 4.15
2m 4.28 4.18
3m 4.32 4.22
4m 4.40 4.30
5m 4.43 4.33
6m 4.50 4.40
9m 4.67 4.57
1y 4.78 4.68
Source: HBOS screen.

Gilt y ields
G RY% D V01 Special rates
5% Ju n 04 4.05
6T Nov 04 4.33 0.00416 100 bp
9H Apr 05 4.668 0.00817 35 bp cheaper than GC
8H Dec 05 4.818 0.014 25 bp cheaper, dow n from 1.5%
7T Sep 06 4.945 0.02141
7H Dec 06 4.966 0.02364 10 bp
Source: Bu tler Secu rities/KSBB screens.

Gilt strip y ields
G RY% D V01
P Ju n 04 3.78
C Sep 04 4.342 0.00195
C Dec 04 4.509 0.00432
C Mar 05 4.633 0.00664
C Ju n 05 4.744 0.00888
C Sep 05 4.829 0.01107
P Dec 05 4.85 0.01321
Source: Bloom berg
Hold strips at 3-m onth, 6-m onth and 9-m onth m atu rities as
longer dated bills and hold to m atu rity . Fu nding w ill be lock ed
in if av ailable or rolled.
For ex am ple, as at 2 Ju ne 2004, XYZ pu rchased a Sep 04

cou pon strip at 4.34% and fu nded in the 1-w eek term at
4.15% (and ran the resu ltant fu nding gap risk – bu t this gilt
had a strong pu ll-to-par effect. If fu nding is no longer
profi table in short dates, XYZ w ou ld hav e sold the gilt for
a probable realized m ark -to-m ark et profi t).
Cou pon strips are bid for in repo by the m ain m ark et-
m ak ers , thereby redu cing liqu idity risk in these produ cts.
Tak e adv antage of special rates for the stock s XYZ is long in.
On 2 Ju ne 2004, a position in 9.5% 2005 gilt w as fu nded
cheaper as a resu lt of its special statu s , from 35 bp (dow n
from 50 bp the w eek before). The 6.75% 2004 gilt w as being
fu nded at 100 bp cheaper than GC. So, the gain on holding
that stock w ou ld be signifi cant, as ou r fu nding cost in repo
w ou ld be v ery low . It w ou ld be an objectiv e of the Treasu ry
desk to be aw are of stock s ex pected to go special and act
accordingly .
Risks
The principle risk is fu nding rollov er (gap risk ). Where possible w e
w ill lock in fu nding to m atch ex pected holding period of positions,
bu t w ill also look to tak e adv antage of m ark et rates as appropriate
and roll ov er fu nding. Gap risk w ill be m anaged in the norm al w ay
as part of ov erall Treasu ry operations. Gaps w ill be pu t on to refl ect
the interest rate and y ield cu rv e v iew of the desk .
There is no credit risk .
Interest rate risk and gap risk are m anaged as a standard bank ing
ALM or cash book . The objectiv e is to set u p an incom e stream
position at low risk , bu t if necessary DV01 risk w ou ld be m anaged
w here deem ed necessary u sing 90-day sterling fu tu res, OIS or
short-dated sw aps. XYZ can also sell ou t of positions w here it
ex pects signifi cant m ark et m ov em ent – for ex am ple, a central
bank base rate hik e. The m ain objectiv e, how ev er, is to establish
an incom e stream , in line w ith a v iew on short-term interest rates.
Hedging w ou ld only be carried ou t w hen necessary for short-term
periods (say , ahead of a data release or anticipated high v olatility ).
As the positions w ou ld be on the trading book – not the bank ing

book – they w ill be m ark ed-to-m ark et. The desk ex pects v olatility
in short-dated gilts to be considerably low er than for m ediu m -
dated and long-dated gilts, bu t v olatility is a risk ex posu re and

there m ay be periods w hen the desk w ill ex perience m ark -to-
m ark et losses.
The interest rate risk for longer dated stock s is show n in Table 5.3,
m easu red as DV01. Longer dated stock s ex pose the bank to a
greater interest rate risk position w hen m ark ing-to-m ark et.
By Moorad Choudhry
Chapter
6
ASSET AND
LIABILITY
MANAGEMENT II
I n ou r second ALM chapter, w e delv e deeper – or m ore accu rately

w ider – into the topic. The art of asset and liability m anagem ent is
essentially one of risk m anagem ent and capital m anagem ent, and
althou gh day -to-day activ ities are ru n at the desk lev el, ov erall direc-
tion is giv en at the highest lev el of a bank ing institu tion. Risk
ex posu res in a bank ing env ironm ent are m u lti-dim ensional; as w e
hav e seen, they encom pas s interest rate risk , liqu idity risk , credit
risk and operational risk . Interest rate risk is one ty pe of m ark et risk .
Risk s associated w ith m ov es in interest rates and lev els of liqu idity 1
are those that resu lt in adv erse fl u ctu ations in earnings lev els du e to
changes in m ark et rates and bank fu nding costs. By defi nition,
bank s’ earnings lev els are highly sensitiv e to m ov es in interest
rates and the cost of fu nds in the w holesale m ark et. Asset and
liability m anagem ent cov ers the set of techniqu es u sed to m anage
interest rate and liqu idity risk s; it also deals w ith the stru ctu re of the
bank ’s balance sheet, w hich is heav ily infl u enced by fu nding and
regu latory constraints and profi tability targets.
In this chapter w e rev iew the concept of balance sheet m anagem ent,
the role of the ALM desk , liqu idity risk and m atu rity gap risk . We
also rev iew a basic gap report. The increasing u se of securitization
and the responsibility of the ALM desk in enhancing the retu rn on
assets on the balance sheet is also introdu ced. For readers w ho are
interested in dev eloping their k now ledge fu rther, w e list a selection
of articles and pu blications in the Bibliography at the end of the
chapter.
INTRODUCTION
For new com ers to the su bject, an ex cellent introdu ction to the
prim ary activ ity of bank ing is contained in an article in The Econ-
omist entitled ‘The bu sines s of bank ing’. 2 Those w ho are com plete
beginners m ay w ish to refer to this article. In this section w e prov ide
an ov erv iew of the m ain bu s iness of bank ing before considering the
su bject of ALM.
One of the m ajor areas of decision-m ak ing in a bank inv olv es the
m atu rity of assets and liabilities. Ty pically , longer term interest
rates are higher than shorter term rates; that is, it is com m on for
In this chapter the term liquidity is u sed to refer to fu nding liqu idity .
The Economist, 30 October 1999.
ASSET AND LIABILITY MANAGEMENT II 169
the y ield cu rv e in the short term (say 0-to-3-y ear range) to be posi-
tiv ely sloping. To tak e adv antage of this bank s u su ally raise a large
proportion of their fu nds from the short-dated end of the y ield cu rv e
and lend ou t these fu nds for longer m atu rities at higher rates. The
spread betw een borrow ing and lending rates is in principle the bank ’s
profi t. The obv iou s risk from su ch a strategy is that the lev el of short-
term rates rises du ring the term of the loan, so that w hen the loan is
refi nanced the bank m ak es a low er profi t or a net loss. Managing
this risk ex posu re is the k ey fu nction of an ALM desk . As w ell as
m anaging the interest rate risk itself, bank s also m atch assets w ith
liabilities – thu s lock ing in a profi t – and div ersify their loan book , to
redu ce ex posu re to one sector of the econom y .
Another risk factor is liqu idity . From a bank ing and Treasu ry point of
v iew the term liquidity m eans fu nding liqu idity , or the ‘nearness’ of
m oney . The m ost liqu id asset is cash m oney . Bank s bear sev eral
interrelated liqu idity risk s, inclu ding the risk of being u nable to pay
depositors on dem and, an inability to raise fu nds in the m ark et at
reasonable rates and an insu ffi cient lev el of fu nds av ailable w ith
w hich to m ak e loans. Bank s k eep only a sm all portion of their
assets in the form of cash, becau se this earns no retu rn for them .
In fact, once they hav e m et the m inim u m cash lev el requ irem ent,
w hich is som ething set dow n by international regu lation (rev iew ed
in the prev iou s chapter), they w ill hold assets in the form of other
instru m ents . Therefore, the ability to m eet deposit w ithdraw als
depends on a bank ’s ability to raise fu nds in the m ark et. The
m ark et and the pu blic’s perception of a bank ’s fi nancial position
heav ily infl u enc es liqu idity . If this v iew is v ery negativ e, the
bank m ay be u nable to raise fu nds and consequ ently be u nable to
m eet w ithdraw als or loan dem and. Thu s, liqu idity m anagem ent is
ru nning a bank in a w ay that m aintains confi dence in its fi nancial
position. The assets of the bank s that are held in near-cash instru -
m ents, su ch as Treasu ry bills and clearing bank CDs, m u st be
m anaged w ith liqu idity considerations in m ind. The asset book
on w hich these instru m ents are held is som etim es called the
liquidity book.
Basic concepts
In the era of stable interest rates that preceded the break dow n of
the Bretton Woods agreem ent, ALM w as a m ore straightforw ard
process, constrained by regu latory restrictions and the sav ing and
borrow ing pattern of bank cu stom ers.3 The introdu ction of the
negotiable certifi cate of deposit by Citibank in the 1960s enabled
bank s to div ersify both their inv estm ent and fu nding sou rces . With
this there dev eloped the concept of interest margin, w hich is the
spread betw een the interest earned on assets and that paid on liabil-
ities. This led to the concept of interest gap and m anagem ent of the
gap, w hich is the cornerstone of m odern-day ALM. The increasing
v olatility of interest rates, and the rise in absolu te lev els of rates
them s elv es, m ade gap m anagem ent a v ital part of ru nning the
bank ing book . This dev elopm ent m eant that bank s cou ld no
longer rely perm anently on the traditional approach of borrow ing
short (fu nding short) to lend long, as a rise in the lev el of short-term
rates w ou ld resu lt in fu nding losses. The introdu ction of deriv ativ e
instru m ents su ch as FRAs and sw aps in the early 1980s rem ov ed the
prev iou s u ncertainty and allow ed bank s to continu e the traditional
approach w hile hedging against m ediu m -term u ncertainty .
Foundations of ALM
The general term asset and liability management entered com m on
u sage from the m id-1970s onw ards . Under a changing-interest-rate
env ironm ent, it becam e im perativ e for bank s to m anage both assets
and liabilities sim u ltaneou s ly , in order to m inim ize interest rate and
liqu idity risk and m ax im ize interest incom e. ALM is a k ey com -
ponent of any fi nancial institu tion’s ov erall operating strategy . As
described in prev iou s tex ts (Marshall and Bansal, 1992, pp. 498–501)
ALM is defi ned in term s of fou r k ey concepts, w hich are described
below .
The fi rst is liquidity, w hich in an ALM contex t does not refer to the
ease w ith w hich an asset can be bou ght or sold in the secondary
For instance, in the US bank ing sector term s on deposit accou nts w ere
fi x ed by regu lation, and there w ere restrictions on the geographic base of
cu stom ers and the interest rates that cou ld be offered. Interest rate
v olatility w as also low . In this env ironm ent ALM consisted prim arily of
asset m anagem ent, in w hich the bank w ou ld u se depositors’ fu nds to
arrange the asset portfolio that w as m ost appropriate for the liability
portfolio. This inv olv ed little m ore than setting aside som e of the assets
in non-interest reserv es at the central bank and inv esting the balance in
short-term secu rities, w hile any su rplu s w ou ld be lent ou t at v ery -short-
term m atu rities.
m ark et, bu t the ease w ith w hich assets can be conv erted into cash.4
A bank ing book is requ ired by the regu latory au thorities to hold a
specifi ed m inim u m share of its assets in the form of v ery liqu id
instru m ents . Liqu idity is v ery im portant to any institu tion that
accepts deposits becau se of the need to m eet cu stom er dem and
for instant access fu nds. In term s of a bank ing book the m ost
liqu id assets are ov ernight fu nds, w hile the least liqu id are
m ediu m -term bonds . Short-term assets su ch as T-bills and CDs
are also considered to be v ery liqu id.
The second k ey concept is the m oney m ark et term structure of

interest rates. The shape of the y ield cu rv e at any one tim e, and
ex pectations as to its shape in the short term and m ediu m term ,
signifi cantly im pact the ALM strategy em ploy ed by a bank . Mark et
risk in the form of interest rate sensitivity, in the form of the present
v alu e sensitiv ity of specifi c instru m ents to changes in the lev el of
interest rates, and in the form of the sensitiv ity of fl oating rate assets
and liabilities to changes in rates are all signifi cant. Another k ey
factor is the maturity profile of the book . The m atu rities of assets and
liabilities can be m atched or u nm atched; althou gh the latter is m ore
com m on the form er is not u ncom m on depending on the specifi c
strategies that are being em ploy ed. Matched assets and liabilities
lock in retu rn in the form of the spread betw een the fu nding rate and
the retu rn on assets. The m atu rity profi le, the absenc e of a lock ed-in
spread and the y ield cu rv e com bine to determ ine the total interest
rate risk of the bank ing book .
The fou rth k ey concept is default risk: the risk ex posu re that
borrow ers w ill defau lt on interest or principal pay m ents that are
du e to the bank ing institu tion.
Thes e issu es are placed in contex t in the sim ple hy pothetical

situ ation described in Box 6.1.
Box 6.1 ALM considerations
Ass u m e that a bank w ants to access the m ark ets for 3-m onth and
6-m onth fu nds, w hether for fu nding or inv estm ent pu rposes. The
The m ark etability defi nition of liqu idity is also im portant in ALM. Less
liqu id fi nancial instru m ents m u st offer a y ield prem iu m that can be
com pared w ith liqu id instru m ents.
rates for these term s are show n in Table 6.1. Assu m e there are no
bid–offer spreads. The ALM m anager also ex pects the 3-m onth
Libor rate in 3 m onths’ tim e to be 5.10% . The bank can u su ally
fu nd its book at Libor w hile it is able to lend at Libor plu s 1% .
Table 6.1 Hy pothetical m oney m ark et rates
Term Libor Bank rate
90-day 5.50% 6.50%

180-day 5.75% 6.75%
Ex pected 90-day rate in 90 day s’ tim e 5.10% 6.10%
3v 6 FRA 6.60%
The bank cou ld adopt any of the follow ing strategies or a

com bination of them :
Borrow 3-m onth fu nds at 5.50% and lend them for a 3-m onth
period at 6.50% . This lock s in a retu rn of 1% for a 3-m onth
period.
period at 6.75% ; again this earns a lock ed-in spread of 1% .
period at 6.75% . This approach w ou ld requ ire the bank to
refu nd the loan in 3 m onths’ tim e, w hich it ex pects to be able
to do at 5.10% . This approach lock s in a retu rn of 1.25% in
the fi rst 3-m onth period and an ex pected retu rn of 1.65% in the
second 3-m onth period. The risk of this tactic is that the
3-m onth rate in 3 m onths’ tim e does not fall as ex pected by
the ALM m anager, redu cing profi ts and possibly leading to
loss.
period at 6.50% . After this period, lend the fu nds for a 3-m onth
or 6-m onth period. This strategy does not tally w ith the ALM
m anager’s v iew , how ev er, w ho ex pects a fall in rates and so
shou ld not w is h to be long of fu nds in 3 m onths’ tim e.
Borrow 3-m onth fu nds at 5.50% and again lend them for a
6-m onth period at 6.75% . To hedge the gap risk , the ALM
m anager sim u ltaneou s ly bu y s a 3v 6 FRA to lock in the
3-m onth rate in 3 m onths’ tim e. The fi rst period spread of
1.25% is gu aranteed, bu t the FRA gu arantees only a spread of
15 basis points in the second period. This is the cost of the
hedge (and also su ggests that the m ark et does not agree
w ith the ALM m anager’s assessm ent of w here rates w ill be
3 m onths from now !); the price the bank m u st pay for redu cing
u ncertainty is low er spread retu rn. Alternativ ely , the bank
cou ld lend for a 6-m onth period, fu nding initially for a
3-m onth period, and bu y an interest rate cap w ith a ceiling
rate of 6.60% that is pegged to Libor, the rate at w hich the bank
can actu ally fu nd its book .
Althou gh sim plistic, these scenarios serv e to illu strate w hat is
possible; indeed, there are m any other strategies that cou ld be
adopted. The approaches described in the last option show how
deriv ativ e instru m ents can activ ely be u sed to m anage the bank ing
book and the cost associated w ith em ploy ing them .
Liquidity and gap management

We hav e noted that the sim plest approach to ALM is to m atch assets
w ith liabilities. For a nu m ber of reasons – inclu ding the need to m eet
client dem and and to m ax im ize retu rn on capital – this is not prac-
tical and bank s m u st adopt m ore activ e ALM strategies. One of the
m ost im portant of these is the role of the gap and gap m anagem ent.
This term describes the practice of v ary ing the asset and liability gap
in response to ex pectations abou t the fu tu re cou rse of interest rates
and the shape of the y ield cu rv e. Sim ply pu t, this m eans increasing
the gap w hen interest rates are ex pected to rise and decreasing it
w hen rates are ex pected to decline. The gap here is the difference
betw een fl oating rate assets and liabilities, bu t gap m anagem ent
m u st also be pu rsu ed w hen one of these elem ents is fi x ed rate.
Su ch a discipline is of cou rse as m u ch an art as a science. Gap
m anagem ent assu m es that the ALM m anager is prov ed to be
correct in his prediction of the fu tu re direction of rates and the
y ield cu rv e.5 View s that tu rn ou t to be incorrect can lead to u n-
ex pected w idening or narrow ing of the gap spread and losses. The
ALM m anager m u st choose the lev el of tradeoff betw een risk and
retu rn.
Gap m anagem ent also assu m es that the profi le of the bank ing book
can be altered w ith relativ e ease. This w as not alw ay s the case, and
ev en today m ay still present problem s, althou gh ev alu ation of a
Or is prov ed to be correct at least three tim es ou t of fi v e !

liqu id m ark et in off-balance-sheet interest rate deriv ativ es has eased

this problem som ew hat. Historically , it has alw ay s been diffi cu lt to
change the stru ctu re of the book , as m any loans cannot be liqu idated
instantly and fi x ed rate assets and liabilities cannot be changed to
fl oating rate ones. Client relationships m u st also be observ ed and
m aintained – a k ey bank ing issu e. For this reason it is m u ch m ore
com m on for ALM m anagers to u se off-balance-sheet produ cts w hen
dy nam ically m anaging the book . For ex am ple, FRAs can be u sed to
hedge gap ex posu re, w hile interest rate sw aps are u sed to alter an
interest basis from fi x ed to fl oating – or v ice v ersa. The last strategy
presented in Box 6.1 presented, albeit sim plistically , the u se that
cou ld be m ade of deriv ativ es. The w idespread u se of deriv ativ es has
enhanced the opportu nities av ailable to ALM m anagers, as w ell as
the fl ex ibility w ith w hich the bank ing book can be m anaged, bu t it
has also contribu ted to an increase in com petition and a redu ction in
m argins and bid–offer spreads.
Interest rate risk and source

Interest rate risk
Pu t sim ply , interest rate risk is defi ned as the potential im pact –
adv erse or otherw ise – on the net asset v alu e of a fi nancial institu -
tion’ s balance sheet and earnings resu lting from a change in interest
rates. Risk ex posu re ex ists w henev er there is a m atu rity date m is-
m atch betw een assets and liabilities, or betw een principal and inter-
est cashfl ow s . Interest rate risk is not necessarily a negativ e thing; for
instance, changes in interest rates that increase the net asset v alu e of
a bank ing institu tion w ou ld be regarded as positiv e. For this reason,
activ e ALM seek s to position a bank ing book to gain from changes in
rates. The Bank for International Settlem ents splits interest rate risk
into tw o elem ents: investment risk and income risk. The fi rst risk
ty pe is the term for potential risk ex posu re arising from changes in
the m ark et v alu e of fi x ed-interest-rate cash instru m ents and off-
balance-sheet instru m ents, and is also k now n as price risk. Inv est-
m ent risk is perhaps best ex em plifi ed by the change in v alu e of a
plain v anilla bond follow ing a change in interest rates, and from
Chapter 2 w e k now that there is an inv ers e relationship betw een
changes in rates and the v alu e of su ch bonds (see Ex am ple 2.2).
Incom e risk is the risk of loss of incom e w hen there is a non-
sy nchronou s change in deposit and fu nding rates – it is this risk
that is k now n as gap risk .
ALM cov ering the form u lation of interest rate risk policy is u su ally
the responsibility of w hat is k now n as the asset–liability com m ittee
(ALCO), w hich is m ade u p of senior m anagem ent personnel
inclu ding the fi nance director and the heads of Treasu ry and risk
m anagem ent. The ALCO sets bank policy for balance sheet m anage-
m ent and the lik ely im pact on rev enu e of v ariou s scenarios that it
considers m ay occu r. The nu m ber of people w ho sit on the ALCO
w ill depend on the com plex ity of the balance sheet and produ cts
traded, as w ell as the am ou nt of m anagem ent inform ation av ailable
on indiv idu al produ cts and desk s.
The process em ploy ed by the ALCO for ALM w ill v ary according to
the particu lar internal arrangem ent of the institu tion. A com m on
procedu re inv olv es a m onthly presentation to the ALCO of the
im pact of different interest rate scenarios on the balance sheet.
This presentation m ay inclu de
Analy sis of the difference betw een actu al net interest incom e
(NII) for the prev iou s m onth and the am ou nt that w as forecast at
the prev iou s ALCO m eeting. This is u su ally presented as a gap
report, brok en by m atu rity bu ck ets and indiv idu al produ cts.
The resu lt of discu s sion w ith bu sines s u nit heads on the basis of
the assu m ptions u sed in calcu lating forecasts and the im pact of
interest rate changes; scenario analy sis u su ally assu m es an u n-
changing book position betw een now and 1 m onth later, w hich is
essentially u nrealistic.
A nu m ber of interest rate scenarios, based on assu m ptions of
(a) w hat is ex pected to happen to the shape and lev el of the
y ield cu rv e, and (b) w hat cou ld conceiv ably happen to it – for
ex am ple, ex trem e scenarios. Essentially , this ex ercise produ ces a
v alu e for forecast NII du e to changes in interest rates.
Update of the lates t actu al rev enu e nu m bers .
Specifi c new or one-off topics m ay be introdu ced at the ALCO as
circu m stances dictate; for ex am ple, presentation of an approv al
process for the introdu ction of a new produ ct.
Sources of interest rate risk

Ass ets on the balance sheet are affected by absolu te changes in
interest rates as w ell as increases in the v olatility of interest
rates. For instance, fi x ed rate assets w ill fall in v alu e in the ev ent
of a rise in rates, w hile fu nding costs w ill rise. This decreases the
m argins av ailable. We noted that the w ay to rem ov e this risk w as to
lock in assets w ith m atching liabilities; how ev er, this is not only not
alw ay s possible, bu t also som etim es u ndesirable, as it prev ents the
ALM m anager from tak ing a v iew on the y ield cu rv e. In a falling
interest rate env ironm ent, deposit-tak ing institu tions m ay ex peri-
ence a decline in av ailable fu nds, requ iring new fu nding sou rces
that m ay be accessed at less fav ou rable term s. Liabilities are also
im pacted by a changing interest rate env ironm ent.
There are fi v e prim ary sou rces of interest rate risk inherent in an
ALM book :
G ap risk is the risk that rev enu e and earnings decline as a resu lt
of changes in interest rates, du e to differences betw een the
m atu rity profi les of assets, liabilities and off-balance-sheet
instru m ents. Another term for gap risk is mismatch risk. An
institu tion w ith gap risk is ex posed to changes in the lev el of
the y ield cu rv e – so-called parallel shift – or change in the shape of
the y ield cu rv e – so-called pivotal shift. Gap risk is m easu red in
term s of short-term or long-term risk , w hich is a fu nction of the
im pact of rate changes on earnings for a short or long period.
Therefore, the m atu rity profi le of the book and the tim e to
m atu rity of instru m ents held on the book w ill infl u ence
w hether the bank is ex posed to short-term or long-term gap risk .
Yield curve risk is the risk that non-parallel or piv otal shifts in
the y ield cu rv e cau se a redu ction in NII. The ALM m anager w ill
change the stru ctu re of the book to tak e into accou nt his v iew s on
the y ield cu rv e. For ex am ple, a book w ith a com bination of short-
term and long-term asset or liability m atu rity stru ctu res 6 is at
risk from y ield cu rv e inv ersion, som etim es k now n as a tw ist in
the cu rv e.
Basis risk arises from the fact that assets are often priced off one
interest rate, w hile fu nding is priced off another interest rate.
Tak en one step fu rther, hedge instru m ents are often link ed to a
different interest rate from that of the produ ct they are hedging.
In the US m ark et the best ex am ple of basis risk is the difference
betw een the Prim e rate and Libor. Term loans in the US are often
set at Prim e, or a relationship to Prim e, w hile bank fu nding is
u su ally based on the Eu rodollar m ark et and link ed to Libor.
How ev er, the Prim e rate is w hat is k now n as an ‘adm inis tered’
rate and does not change on a daily basis – u nlik e Libor. While
changes in the tw o rates are positiv ely correlated, they do not
This describes a barbell stru ctu re, bu t this is really a bond m ark et term .
Figure 6.1 Change in spread betw een Prim e rate and USD 3-m onth
Libor 2009–2010.
Bloom berg L.P. Used w ith perm ission. Visit w w w .bloom berg.com .
change by the sam e am ou nt, w hich m eans that the spread

betw een them changes regu larly . This resu lts in spread
earning on a loan produ ct changing ov er tim e. Figu re 6.1
illu strates the change in spread du ring 2009–2010.
Another risk for deposit-tak ing institu tions su ch as clearing
bank s is runoff risk, associated w ith the non-interest-bearing
liabilities (NIBLs) of su ch bank s. The lev el of interest rates at
any one tim e represents an opportu nity cost to depositors w ho
hav e fu nds in su ch facilities. How ev er, in a rising-interes t-rate
env ironm ent, this opportu nity cost rises and depositors w ill
w ithdraw these fu nds, av ailable at im m ediate notice, resu lting
in an ou tfl ow of fu nds from the bank . The fu nds m ay be tak en ou t
of the bank ing sy stem com pletely ; for ex am ple, for inv estm ent
in the stock m ark et. This risk is signifi cant and therefore su ffi -
cient fu nds m u st be m aintained at short notice, w hich is an
opportu nity cost for the bank itself.
Many bank ing produ cts entitle the cu stom er to term inate
contractu al arrangem ents ahead of the stated m atu rity term ;
this is som etim es referred to as option risk. This is another
signifi cant risk as produ cts – su ch as CDs, chequ e accou nt bal-

ances and dem and deposits – can be w ithdraw n or liqu idated at
no notice, w hich is a risk to the lev el of NII shou ld the option
inherent in the produ cts be ex ercised.
Gap and net interest income

We noted earlier that gap is a m easu re of the difference betw een the
interest rate sensitiv ity of assets and liabilities that rev alu e at a
particu lar date, ex pressed as a cash v alu e. Pu t sim ply it is
Gap A ir L ir 61
w here A ir and L ir are interest-rate-sensitiv e assets and interest-rate-
sensitiv e liabilities. Where A ir L ir the bank ing book is described as
being positively gapped, and w hen A ir L ir the book is said to be
negativ ely gapped. The change in NII is giv en by
NII Gap r 62
w here r is the relev ant interest rate u sed for v alu ation. The NII of a
bank that is positiv ely gapped w ill increase as interest rates rise and
decrease as rates decline. This describes a bank ing book that is asset
sensitiv e; the opposite, w hen a book is negativ ely gapped, is k now n
as liability sensitiv e. The NII of a negativ ely gapped book w ill
increase w hen interest rates decline. The v alu e of a book w ith
zero gap is im m u ne to changes in the lev el of interest rates. The
shape of the bank ing book at any one tim e is a fu nction of cu stom er
dem and, the Treasu ry m anager’s operating strategy , as w ell as a v iew
of fu tu re interest rates.
Gap analy sis is u sed to m easu re the difference betw een interest-rate-
sensitiv e assets and liabilities ov er specifi ed tim e periods. Another
term for this analy sis is periodic gap, and the com m on ex pression for
each tim e period is a maturity bucket. For a com m ercial bank ty pical
m atu rity bu ck ets are:
0–3 m onths;
3–12 m onths;
1–5 y ears;
5 y ears.
Another com m on approach is to grou p assets and liabilities by the
bu ck ets or grid points of the Riskmetrics v alu e-at-risk m ethodology .
Moreov er, any com bination of tim e periods m ay be u sed. For in-
stance, certain US com m ercial bank s place assets, liabilities and off-
balance-sheet item s in term s of known maturities, judgemental

maturities and market-driven maturities:
known maturities are fi x ed rate loans and CDs;
judgemental maturities are passbook sav ings accou nts, dem and
deposits, credit cards and non-perform ing loans;
market-driven maturities are option-based instru m ents su ch as
m ortgages and other interest-rate-sensitiv e assets.
The other k ey m easu re is cumulative gap, defi ned as the su m of
indiv idu al gaps u p to 1-y ear m atu rity . Bank s traditionally u se
cu m u lativ e gap to estim ate the im pact of a change in interest
rates on NII.
Assumptions of gap analysis

A nu m ber of assu m ptions are m ade w hen u sing gap analy sis, bu t
they m ay not refl ect reality in practice. Thes e inclu de
The k ey assu m ption that interest rate changes m anifest
them selv es as a parallel shift in the y ield cu rv e; in practice,
changes do not occu r as a parallel shift, giv ing rise to basis
risk betw een short-term and long-term assets.
The ex pectation that contractu al repay m ent schedu les are m et; if
there is a fall in interest rates, prepay m ents of loans by borrow ers
w ho w is h to refi nance their loans at low er rates w ill hav e an
im pact on NII. Certain assets and liabilities hav e option featu res
that are ex ercised as interest rates change, su ch as letters of credit
and v ariable rate deposits; early repay m ent w ill im pact a bank ’s
cashfl ow .
The ex pectation that repricing of assets and liabilities tak es place
at the m idpoint of the tim e bu ck et.
The ex pectation that all loan pay m ents w ill occu r on schedu le; in
practice, certain borrow ers w ill repay the loan earlier.
Recognized w eak nes ses of the gap approach inclu de
no incorporation of fu tu re grow th, or changes in the asset/
liability m ix ;
no consideration of the tim e v alu e of m oney ;
arbitrary setting of tim e periods.
Lim itations notw ithstanding, gap analy sis is u sed ex tensiv ely . Gu p
and Brook s (1993, p. 59) giv e the follow ing reasons for the continu ed
popu larity of gap analy sis:
it w as the fi rst approach introdu ced to handle interest rate risk –

it prov ides reasonable accu racy ;
the data requ ired to perform the analy sis hav e already been
com piled for the pu rposes of regu latory reporting;
gaps can be calcu lated u sing sim ple spreadsheet softw are;
it is easier (and cheaper) to im plem ent than m ore sophisticated
techniqu es;
it is straightforw ard to dem onstrate and ex plain to senior
m anagem ent and shareholders.
Althou gh there are m ore sophisticated m ethods av ailable, gap
analy sis rem ains in w idespread u se.
THE BANKING BOOK

Traditionally , ALM has been concerned w ith the bank ing book . The
conv entional techniqu es of ALM w ere dev eloped for application to a
bank ’s bank ing book – that is, its lending and deposit-tak ing transac-
tions. The core bank ing activ ity w ill generate either an ex cess of
fu nds (w hen the receipt of deposits ou tw eighs the v olu m e of lending
the bank has u ndertak en) or a shortage of fu nds (w hen the rev erse
occu rs). This m is m atch is balanced v ia fi nancial transactions in the
w holesale m ark et. The bank ing book generates both interest rate and
liqu idity risk s , w hich are then m onitored and m anaged by the ALM
desk . Interest rate risk is the risk that the bank su ffers losses du e to
adv erse m ov em ents in m ark et interest rates. Liqu idity risk is the
risk that the bank cannot generate su ffi cient fu nds w hen requ ired;
the m ost ex trem e v ersion of this is w hen there is a ru n on the
bank and the bank cannot raise the fu nds requ ired w hen depositors
w ithdraw their cash.
Note that the asset side of the bank ing book – that is, the loan
portfolio – also generates credit risk .
The ALM desk w ill be concerned w ith risk m anagem ent that focu ses
on the qu antitativ e m anagem ent of liqu idity and interest rate risk s
inherent in a bank ing book . The m ajor areas of ALM inclu de
Measurement and monitoring of liquidity and interest rate risk.
This inclu des setting u p targets for earnings and the v olu m e of
transactions , as w ell as setting u p and m onitoring interest rate
risk lim its.
Funding and control of any constraints on the balance sheet.

This inclu des liqu idity constraints and debt policy as w ell as the
capital adequacy ratio and solv ency .
H edging of liquidity and interest-rate risk.
THE ALM DESK

The ALM desk or u nit is a specialized bu s iness u nit that fu lfi ls a
range of fu nctions. Its precis e rem it is a fu nction of the ty pe of
activ ities of the fi nancial institu tion it is a part of. Let u s consider
the m ain ty pes of activ ities that are carried ou t.
If an ALM u nit has a profi t target of zero, it w ill act as a cost centre
w ith a responsibility to m inim ize operating costs. This w ou ld be
consistent w ith a strategy that em phasizes com m ercial bank ing as
the core bu sines s of the fi rm , and w here ALM policy is concerned
pu rely w ith hedging interest rate and liqu idity risk .
The nex t stage of dev elopm ent is w here the ALM u nit is responsible
for m inim izing the cost of fu nding. This w ou ld allow the u nit to
m aintain an elem ent of ex posu re to interest rate risk , depending on
the v iew that w as held as to the fu tu re lev el of interest rates. As w e
noted abov e, the core bank ing activ ity generates either an ex cess or
shortage of fu nds. To hedge aw ay all the ex cess or shortage, w hile
rem ov ing interest rate ex posu re, has an opportu nity cost associated
w ith it since it elim inates any potential gain that m ight arise from
m ov em ents in m ark et rates. Of cou rse, w ithou t a com plete hedge,
there is ex posu re to interest rate risk . The ALM desk is responsible
for m onitoring and m anaging this risk and, of cou rse, is credited w ith
any cost sav ings in the cost of fu nds that arise from ex posu re. Sav ings
m ay be m easu red as the difference betw een the fu nding costs of a fu ll
hedging policy and the actu al policy that the ALM desk adopts.
Under this policy , interest rate risk lim its are set w hich the ALM
desk ensu res the bank ’s operations do not breach.
The fi nal stage of dev elopm ent is to tu rn the ALM u nit into a profi t
centre, w ith responsibility for optim izing the fu nding policy w ithin
specifi ed lim its . The lim its m ay be set as gap lim its, value-at-risk
lim its or by another m easu re – su ch as the lev el of earnings v olatility .
Under this scenario the ALM desk is responsible for m anaging all
fi nancial risk .
The fi nal dev elopm ent of the ALM fu nction has resu lted in it tak ing
on a m ore activ e role. The prev iou s paragraphs described the three
stages of dev elopm ent that ALM has u ndergone, althou gh all three
v ersions are part of the ‘traditional’ approach. Practitioners are now
beginning to think of ALM as ex tending bey ond the risk m anage-
m ent fi eld and being responsible for adding v alu e to the net w orth of
the bank , throu gh proactiv e positioning of the book and, hence, the
balance sheet. That is, in addition to the traditional fu nction of
m anaging liqu idity risk and interest rate risk , ALM shou ld be con-
cerned w ith m anaging the regu latory capital of the bank and w ith
activ ely positioning the balance sheet to m ax im ize profi t. The latest
dev elopm ents m ean that there are now fi nancial institu tions that
ru n a m u ch m ore sophisticated ALM operation than that associated
w ith a traditional bank ing book .
Let u s rev iew the traditional and dev eloped elem ents of an ALM
fu nction.
Traditional ALM
Generally , in the past a bank ’s ALM fu nction has been concerned
w ith m anaging the risk associated w ith the bank ing book . This does
not m ean that this fu nction is now obsolete, rather that additional
fu nctions hav e now been added to the ALM role. There are a large
nu m ber of fi nancial institu tions that adopt the traditional approach;
indeed, the natu re of their operations w ou ld not lend them selv es to
any thing m ore. We can su m m arize the role of the traditional ALM
desk as follow s:
Interest rate risk management. This is the interest rate risk
arising from operation of the bank ing book . It inclu des net inter-
est incom e sensitiv ity analy sis – ty pifi ed by m atu rity gap and
du ration gap analy sis – and sensitiv ity of the book to parallel
changes in the y ield cu rv e. The ALM desk w ill m onitor the
ex posu re and position the book in accordance w ith its lim its
as w ell as its m ark et v iew . Sm aller bank s, or su bsidiaries of
bank s that are based ov erseas , often ru n no interest rate risk –
that is, there is no short gap in their book . Apart from this,
the ALM desk is responsible for hedging interest rate risk or
positioning the book in accordance w ith its v iew .
Liquidity and funding management. There are regu latory
requ irem ents that dictate the proportion of bank ing assets that
m u st be held as short-term instru m ents . The liqu idity book in
a bank is responsible for ru nning the portfolio of short-term
instru m ents. The ex act m ak eu p of the book is, how ev er, the
responsibility of the ALM desk and w ill be a fu nction of the

desk ’s v iew of m ark et interest rates, as w ell as its opinion on
the relativ e v alu e of one asset ov er another. For ex am ple, it m ay
decide to m ov e som e assets into short-dated gov ernm ent bonds ,
in ex cess of w hat it norm ally holds, at the ex pense of high-qu ality
CDs, or v ice v ersa.
Reporting on hedging of risks. The ALM fu lfi ls a senior
m anagem ent inform ation fu nction by regu larly reporting on
the ex tent of the bank ’s risk ex posu re. This m ay be in the
form of a w eek ly hardcopy report or v ia som e other m ediu m .
Setting up risk limits. The ALM u nit w ill set lim its , im plem ent
them and enforce them , althou gh it is com m on for an indepen-
dent ‘m iddle offi ce’ risk fu nction to m onitor com pliance w ith
lim its.
C apital requirement reporting. This fu nction inv olv es the
com pilation of reports on capital u s age and position lim its as a
percentage of capital allow ed, as w ell as reporting to regu latory
au thorities.
All fi nancial institu tions carry ou t these activ ities.
Example 6.1 Gap analy sis
Maturity gap analy sis m easu res the cash difference or gap betw een
the absolu te v alu es of assets and liabilities that are sensitiv e to
m ov em ents in interest rates. Therefore, the analy sis m easu res the
relativ e interest rate sensitiv ities of assets and liabilities, and thu s
determ ines the risk profi le of the bank w ith respect to changes in
rates. The gap ratio is giv en as:
Interest Rate-sensitiv e assets
Gap ratio 61
Interest Rate-sensitiv e liabilities
It m easu res w hether there are m ore interest-rate-sensitiv e assets
than liabilities. A gap ratio higher than 1, for ex am ple, indicates
that a rise in interest rates w ill increase the net present v alu e of the
book , thu s raising the retu rn on assets at a rate higher than the rise
in the cost of fu nding. This also resu lts in a higher incom e spread.
A gap ratio low er than 1 indicates a rising fu nding cost. D uration
gap analy sis m easu res im pact on the net w orth of the bank du e to
changes in interest rates by focu sing on changes in the m ark et
v alu e of either assets or liabilities. This is becau se the du ration gap
m easu res the percentage change in the m ark et v alu e of a single
secu rity for a 1% change in the u nderly ing y ield of the secu rity
(strictly speak ing, this is modified duration bu t the term for the
original ‘du ration’ is now alm ost u niv ers ally u sed to refer to
m odifi ed du ration). The du ration gap is defi ned as:
Du ration gap Du ration of assets w(Du ration of liabilities)
62
w here w is the percentage of assets fu nded by liabilities. Hence,
the du ration gap m easu res the effects of change on the net w orth of
the bank . A higher du ration gap indicates higher interest rate
ex posu re. As the du ration gap only m easu res the effects of a linear
change in interest rate – that is, a parallel shift in y ield cu rv e
change – bank s w ith portfolios that inclu de a signifi cant am ou nt of
instru m ents w ith elem ents of optionality (su ch as callable bonds ,
asset-back ed secu rities and conv ertibles) also u se the convexity
m easu re of risk ex posu re to adju st for inaccu racies that arise in the
du ration gap ov er large y ield changes.
DEVELOPMENTS IN ALM
An increasing nu m ber of fi nancial institu tions hav e been enhancing
their risk m anagem ent fu nction by adding to the responsibilities of
the ALM fu nction. Thes e hav e inclu ded enhancing the role of the
head of Treasu ry and the ALCO – by u sing su ch other risk ex posu re
m easu res as option-adju sted spread and v alu e-at-risk (VaR) – and
integrating traditional interest rate risk m anagem ent w ith credit
risk and operational risk . The increasing u se of credit deriv ativ es
has facilitated this integrated approach to risk m anagem ent.
Additional roles play ed by the ALM desk m ay inclu de
u sing the VaR tool to assess risk ex posu re;
integrating m ark et risk and credit risk ;
u sing new risk-adjusted m easu res of retu rn;
optim izing portfolio retu rn;
proactiv ely m anaging the balance sheet – this inclu des giv ing
direction on the secu ritization of assets (rem ov ing them from the
balance sheet), hedging credit ex posu re u sing credit deriv ativ es
and activ ely enhancing retu rns from the liqu idity book , su ch as
entering into stock lending and repo.
An enhanced ALM fu nction w ill by defi nition ex pand the role of
the Treasu ry fu nction and the ALCO. This m ay see the Treasu ry
fu nction becom ing activ e ‘portfolio m anagers’ of the bank ’s book .

The ALCO – traditionally com posed of risk m anagers from across
the bank as w ell as the senior m em ber of the ALM desk or liqu idity
desk – is responsible for assisting the head of Treasu ry and the
fi nance director in the risk m anagem ent process. In order to fu lfi l
the new enhanced fu nction the treasu rer w ill requ ire a m ore strat-
egic approach to his fu nction, as m any of the decisions abou t ru nning
the bank ’s entire portfolio w ill be closely connected w ith the ov erall
direction that the bank w ishes to tak e – these are board-lev el
decisions.
LIQUIDITY AND INTEREST RATE RISK

The liquidity gap
Liqu idity risk arises becau se a bank ’s portfolio consists of assets and
liabilities w ith different sizes and m atu rities. When assets ex ceed
the resou rces from operations, a fu nding gap w ill ex ist w hich needs
to be sou rced in the w holesale m ark et. When the opposite occu rs,
ex cess resou rces m u st be inv ested in the m ark et. The difference
betw een assets and liabilities is called the liquidity gap. For
ex am ple, if a bank has long-term com m itm ents that hav e arisen
from its dealings – and its resou rces are ex ceeded by these com m it-
m ents and hav e a shorter m atu rity – there is both an im m ediate and a
fu tu re defi cit. The liqu idity risk for the bank is that there are not
enou gh resou rces or fu nds av ailable in the m ark et to balance the
assets at any tim e.
Liqu idity m anagem ent has sev eral objectiv es; possibly the m ost
im portant is to ensu re that defi cits can be fu nded u nder all foreseen
circu m stances and w ithou t incu rring prohibitiv e costs. In addition,
there are regu latory requ irem ents that force a bank to operate certain
lim its; these requ irem ents state that short-term assets m u st be in
ex cess of short-ru n liabilities in order to prov ide a safety net of highly
liqu id assets. Liqu idity m anagem ent is also concerned w ith fu nding
defi cits and inv esting su rplu s es, w ith m anaging and grow ing the
balance sheet and w ith ensu ring that the bank operates w ithin
regu latory and in-hou s e lim its . In this section w e rev iew the
m ain issu es concerned w ith liqu idity and interest rate risk .
The liqu idity gap is the difference at all fu tu re dates betw een the
assets and liabilities of the bank ing portfolio. Gaps generate liqu idity
risk . When liabilities ex ceed assets, there is an ex cess of fu nds. An
ex cess does not of cou rse generate liqu idity risk , bu t it does generate
interest rate risk , becau se the present v alu e of the book is sensitiv e to
changes in m ark et rates. When assets ex ceed liabilities, there is a
fu nding defi cit and the bank has long-term com m itm ents that are
not cu rrently fu nded by ex isting operations. The liqu idity risk is that
the bank requ ires fu nds at a fu tu re date to m atch the assets. The bank
is able to rem ov e any liqu idity risk by lock ing in m atu rities, bu t
there is of cou rse a cost inv olv ed as it w ill be dealing at longer
m atu rities.7
Gap risk and lim its

Liqu idity gaps are m easu red by tak ing the difference betw een the
ou tstanding balances of assets and liabilities ov er tim e. At any point
a positiv e gap betw een assets and liabilities is equ iv alent to a defi cit,
and this is m easu red as a cash am ou nt. Marginal gap is the difference
betw een changes in assets and liabilities ov er a giv en period. A
positiv e m arginal gap m eans that v ariation in the v alu e of assets
ex ceeds v ariation in the v alu e of liabilities. As new assets and
liabilities are added ov er tim e – as part of the ordinary cou rse of
bu s iness – the gap profi le changes.
The gap profi le is tabu lated or charted (or both) du ring and at the end
of each day as a prim ary m easu re of risk . For illu strativ e pu rposes, a
tabu lated gap report is show n in Table 6.2; this is an actu al ex am ple
from a UK bank ing institu tion. It show s assets and liabilities
grou ped into m atu rity bu ck ets and the net position for each
bu ck et. It is a snapshot today of the ex posu re – and hence fu nding
requ irem ent – of the bank for fu tu re m atu rity periods.
Table 6.2 is v ery m u ch a su m m ary fi gu re, becau se the m atu rity gaps
are v ery w ide. For risk m anagem ent pu rposes the bu ck ets w ou ld be
m u ch narrow er; for instance, the period betw een 0 and 12 m onths
m ight be split into 12 different m atu rity bu ck ets. An ex am ple of a
m ore detailed gap report is show n in Figu re 6.2, w hich is from
another UK bank ing institu tion. Note that the ov erall net position
is zero, becau se this is a balance sheet and therefore, not su rprisingly ,
it balances . How ev er, along the m atu rity bu ck ets or grid points there
are net positions w hich are the gaps that need to be m anaged. A fu ll
gap report is show n at Table 6.3.
This assu m es a conv entional u pw ard-sloping y ield cu rv e.

Table 6.2 Ex am ple gap profi le
Tim e periods
6–12 m onths
0–6 m onths
1–3 y ears
3–7 y ears
7+ y ears
Assets Total
40,533 28,636 3,801 4,563 2,879 654
6.17% 6.08% 6.12% 6.75% 6.58% 4.47%
Liabilities 40,533 30,733 3,234 3,005 2,048 1,513
4.31% 4.04% 4.61% 6.29% 6.54% 2.21%
N et cumulative positions 0 (2,097) 567 1,558 831 (859)
1.86%
Margin on total assets 2.58%

Av erage m argin on total assets 2.53%
Figure 6.2 Gap lim it report.
Lim its on a bank ing book can be set in term s of gap lim its. For
ex am ple, a bank m ay set a 6-m onth gap lim it of £10 m illion. The
net position of assets and m atu rities ex piring in 6 m onths’ tim e
w ou ld not then ex ceed £10 m illion. An ex am ple of a gap lim it
report is show n at Figu re 6.2, w ith actu al net gap positions show n
against the gap lim its for each m atu rity . Again this is an actu al lim it
report from a UK bank ing institu tion.
The m atu rity gap can be charted to prov ide an illu stration of net
ex posu re. An ex am ple is show n in Figu re 6.3, w hich is from y et
another UK bank ing institu tion. In som e fi rm s’ reports both
Table 6.3 Detailed gap profi le.
6 m onths to 1 y ear
Up to 1 m onth
1–3 m onths
3–6 m onths
Total (£m )
Assets
Cash and interbank loans 2,156.82 1,484.73 219.36 448.90 3.84
Certifi cates of deposit pu rchased 1,271.49 58.77 132.99 210.26 776.50
Floating rate notes pu rchased 936.03 245.62 586.60 12.68 26.13
Bank bills 314.35 104.09 178.36 31.90 0.00
Other loans 13.00 0.00 1.00 0.00 0.00
Debt secu rities/Gilts 859.45 0.00 25.98 7.58 60.05
Fix ed rate m ortgages 4,180.89 97.72 177.37 143.13 964.98
Variable and capped rate m ortgages 14,850.49 14,850.49 0.00 0.00 0.00
Com m ercial loans 271.77 96.62 96.22 56.52 0.86
Unsecu red lending and leasing 3,720.13 272.13 1,105.20 360.03 507.69
Other assets 665.53 357.72 0.00 18.77 5.00
Total cash assets 29,239.95 17.567.91 2,523.06 1,289.77 2,345.05
Sw aps 9,993.28 3,707.34 1,462.32 1,735.59 1,060.61

Forw ard rate agreem ents 425.00 0.00 50.00 0.00 220.00
Fu tu res 875.00 0.00 300.00 0.00 175.00
Total 40,533.24 21,275.24 4,335.38 3,025.36 3,800.66
Liabilities
Bank deposits 3,993.45 2,553.85 850.45 233.03 329.06
Certifi cates of deposit issu ed 1,431.42 375.96 506.76 154.70 309.50
Com m ercial paper – CP and eu ro 508.46 271.82 128.42 108.21 0.00
Su bordinated debt 275.00 0.00 0.00 0.00 0.00
Eu robonds Other 2,582.24 768.75 1,231.29 121.94 53.86
Cu stom er deposits 17,267.55 15,493.65 953.60 311.70 340.50
Other liabilities 3,181.83 1,336.83 0.00 0.00 741.72
(incl. capital/reserv es)
Total cash liabilities 29,239.96 20,800.86 3,670.52 929.58 1,774.64
Sw aps 9,993.28 1,754.70 1,657.59 1,399.75 1,254.24

Forw ard rate agreem ents 425.00 0.00 150.00 70.00 55.00
Fu tu res 875.00 0.00 0.00 300.00 150.00
Total 40,533.24 22,555.56 5,478.11 2,699.33 3,233.89
Net positions 0.00 1,351.09 1,234.54 265.58 583.48

9–10 y ears
10+ y ears
1–2 y ears
2–3 y ears
3–4 y ears
4–5 y ears
5–6 y ears
6–7 y ears
7–8 y ears
8–9 y ears
0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
92.96 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
45.48 0.00 0.00 19.52 0.00 0.00 0.00 0.00 0.00 0.00
0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
7.00 0.00 1.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
439.06 199.48 26.81 100.50 0.00 0.00 0.00 0.00 0.00 0.00
1,452.91 181.86 661.36 450.42 22.78 4.30 3.65 3.10 2.63 14.67
0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
2.16 1.12 3.64 8.85 1.06 0.16 0.17 0.16 4.23 0.00
694.86 400.84 195.19 79.98 25.45 14.06 10.03 10.44 10.82 33.42
0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
2,734.43 783.31 888.00 659.26 49.28 20.53 15.85 13.71 17.68 332.12
344.00 146.50 537.60 649.00 70.00 5.32 200.00 75.00 0.00 0.00
5.00 150.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
400.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
3,483.43 1,079.81 1,425.60 1,308.26 119.28 25.84 215.85 88.71 17.68 332.12
21.07 1.00 0.00 5.00 0.00 0.00 0.00 0.00 0.00 0.00
60.00 20.0 3.50 1.00 0.00 0.00 0.00 0.00 0.00 0.00
0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
0.00 0.00 0.00 0.00 0.00 0.00 200.00 75.00 0.00 0.00
9.77 13.16 150.43 150.43 0.00 7.51 0.00 0.00 0.00 75.00
129.10 6.60 24.90 0.00 7.50 0.00 0.00 0.00 0.00 0.00
0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1,103.28
219.93 40.76 178.83 156.53 7.50 7.51 200.00 75.00 0.00 1,178.28
1,887.97 281.44 905.06 770.52 15.76 6.48 7.27 8.13 13.06 31.30
150.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
425.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
2,682.90 322.20 1,083.90 927.05 23.26 13.99 207.27 83.13 13.06 1,209.58
929.10 803.46 341.70 404.88 104.28 11.85 8.58 5.57 4.62 877.45
Figure 6.3 Gap m atu rity profi le in graphical form .
assets and liabilities are show n for each m atu rity point, bu t in ou r
ex am ple only the net position is show n. This net position is the gap
ex posu re for that m atu rity point. A second ex am ple, u sed by the
ov erseas su bsidiary of a m iddle eastern com m ercial bank , w hich has
no fu nding lines in the interbank m ark et and so does not ru n short
positions, is show n at Figu re 6.4, w hile the gap report for a UK high-
street bank is show n in Figu re 6.5. Note the large short gap u nder the
m atu rity labelled ‘non-int’; this stands for non-interest-bearing
liabilities and represents the balance of cu rrent accou nts (chequ e
or ‘check ing’ accou nts) w hich are fu nds that attract no interest and
are in theory v ery short-dated (becau s e they are dem and deposits and
m ay be called at instant notice).
Figure 6.4 Gap m atu rity profi le of a bank w here short fu nding is
not allow ed.
Figure 6.5 Gap m atu rity profi le of a UK high-s treet bank .
Gaps represent the cu m u lativ e fu nding requ ired at all dates.

Cu m u lativ e fu nding is not necessarily identical to the new
fu nding requ ired at each period, becau se the debt issu ed in prev iou s
periods is not necessarily am ortized at su bsequ ent periods. The
new fu nding betw een, for ex am ple, Months 3 and 4 is not the
accu m u lated defi cit betw een Months 2 and 4 becau se the debt con-
tracted at Month 3 is not necessarily am ortized at Month 4. Marginal
gaps m ay be identifi ed as the new fu nding requ ired or the new ex cess
fu nds of the period that shou ld be inv ested in the m ark et. Note that
all the reports are snapshots at a fi x ed point in tim e and the pictu re is,
of cou rse, continu ou sly m ov ing. In practice, the liqu idity position of
a bank cannot be characterized by one gap at any giv en date; the
entire gap profi le m u st be u sed to gau ge the ex tent of the book ’s
profi le.
The liqu idity book m ay decide to m atch its assets w ith its liabilities.
This is k now n as cash matching and occu rs w hen the tim e profi les of
assets and liabilities are identical. By follow ing su ch a cou rse the
bank can lock in the spread betw een its fu nding rate and the rate at
w hich it lends cash, and ru n a gu aranteed profi t. Under cash m atch-
ing the liqu idity gaps w ill be zero. Matching the profi le of both legs of
the book is done at the ov erall lev el; that is, cash m atching does not
m ean that deposits shou ld alw ay s m atch loans. This w ou ld be
diffi cu lt as both resu lt from cu stom er dem and, althou gh an indi-
v idu al pu rchase of, say , a CD can be m atched w ith an identical loan.
Nev ertheless, the bank can elect to m atch assets and liabilities once
the net position is k now n, and k eep the book m atched at all tim es.
How ev er, it is highly u nu s u al for a bank to adopt a cash-m atching
strategy .
Liquidity m anagem ent

The continu ou s process of raising new fu nds or inv esting su rplu s
fu nds is k now n as liqu idity m anagem ent. If w e consider that the gap
today is fu nded – thu s balancing assets and liabilities and squ aring off
the book – the nex t day a new defi cit or su rplu s is generated w hich
also has to be fu nded. The liqu idity m anagem ent decision m u st
cov er the am ou nt requ ired to bridge the gap that ex ists the follow ing
day and to position the book across fu tu re dates in line w ith the
bank ’s v iew on interest rates. Usu ally , in order to ascertain the
m atu rity stru ctu re of debt a target profi le of resou rces is defi ned.
This m ay be done in sev eral w ay s. If the objectiv e of ALM is to
replicate the asset profi le w ith resou rces, the new fu nding shou ld
contribu te to bringing the resou rces profi le closer to that of the
assets; that is, m ore of a m atched book look ing forw ard. This is
the low est risk option. Another target profi le m ay be im pos ed on
the bank by liqu idity constraints. This m ay arise if, for ex am ple, the
bank has a lim it on borrow ing lines in the m ark et su ch that it cou ld
not raise a certain am ou nt each w eek or m onth. For instance, if the
m ax im u m that cou ld be raised in one w eek by a bank is £10 m illion,
the m ax im u m period liqu idity gap is constrained by that lim it. The
ALM desk w ill m anage the book in line w ith the target profi le that
has been adopted, w hich requ ires it to try to reach the requ ired
profi le ov er a giv en tim e horizon.
Managing the liqu idity of the bank ing book is a dy nam ic process, as
loans and deposits are k now n at any giv en point, bu t new bu s iness
w ill be tak ing place continu ou sly and the profi le of the book look ing
forw ard m u st be constantly rebalanced to k eep it w ithin the target
profi le. There are sev eral factors that infl u ence this dy nam ic process,
the m ost im portant of w hich are rev iew ed below .
Demand deposits
Deposits placed on dem and at the bank – su ch as cu rrent accou nts
(k now n in the US as ‘check ing accou nts’) – hav e no stated m atu rity
and are av ailable on dem and at the bank . Technically , they are
referred to as ‘non-interest-bearing liabilities’ becau se the bank
pay s no or v ery low rates of interest on them , so they are effectiv ely
free fu nds. The balance of these fu nds can increase or decrease
throu ghou t the day w ithou t any w arning, althou gh in practice the
balance is qu ite stable. There are a nu m ber of w ay s that a bank can
choose to deal w ith these balances:
By grou ping all ou tstanding balances into one m atu rity bu ck et at

a fu tu re date chosen to be the preferred tim e horizon of the bank ,
or a date bey ond this. This w ou ld then ex clu de them from the gap
profi le. Althou gh this is considered u nrealistic becau se it
ex clu des cu rrent accou nt balances from the gap profi le, it is
nev ertheless a fairly com m on approach.
By rely ing on an assu m ed rate of am ortization for the balances –
say , 5% or 10% each y ear.
By div iding deposits into stable and u nstable balances , the core
deposits of w hich are set as a perm anent balance. The am ou nt of
the core balance is set by the bank based on a stu dy of the total
balance v olatility pattern ov er tim e. The ex cess ov er the core
balance is then v iew ed as v ery short-term debt. This m ethod
is reasonably close to reality as it is based on historical
observ ations.
By m ak ing projections based on observ able v ariables that are
correlated w ith the ou tstanding balances of deposits. For in-
stance, su ch v ariables cou ld be based on the lev el of econom ic
grow th plu s an error factor based on short-term fl u ctu ations in
the grow th pattern.
Preset contingencies
A bank w ill hav e com m itted lines of credit, the u tilization of w hich
w ill depend on cu stom er dem and. Contingencies generate ou tfl ow s
of fu nds that are by defi nition u ncertain, as they are contingent u pon
som e ev ent – for ex am ple, the w illingness of the borrow er to u se a
com m itted line of credit. The u su al w ay for a bank to deal w ith these
u nforeseen fl u ctu ations is to u se statistical data based on past
observ ations to project a fu tu re lev el of activ ity .
Prepayment options of existing assets

Where the m atu rity schedu le is stated in term s of a loan, it m ay still
be su bject to u ncertainty becau se of prepay m ent options. This is
sim ilar to the prepay m ent risk associated w ith a m ortgage-back ed
bond. An elem ent of prepay m ent risk renders the actu al m atu rity
profi le of a loan book as u ncertain; bank s often calcu late an ‘effectiv e
m atu rity schedu le’ based on prepay m ent statistics instead of the
theoretical schedu le. There are also a range of prepay m ent m odels
that m ay be u sed, the sim plest of w hich u se constant prepay m ent
ratios to asses s the av erage life of the portfolio. More sophisticated
m odels incorporate m ore param eters, lik e basing the prepay m ent
Figure 6.6 Liqu idity analy sis for a UK retail bank .
rate on the interest rate differential betw een the loan rate and the
cu rrent m ark et rate or on the tim e elapsed since the loan w as tak en
ou t.
Interest cashflows
Ass ets and liabilities generate interest cash infl ow s and ou tfl ow s, in
addition to am ortization of principal. Interest pay m ents m u st be
inclu ded in the gap profi le as w ell.
Interest rate gap

The interest rate gap is the standard m easu re of the ex posu re of the
bank ing book to interest rate risk . The interest rate gap for a giv en
period is defi ned as the difference betw een fi x ed rate assets and fi x ed
rate liabilities. It can also be calcu lated as the difference betw een
interest-rate-sensitiv e assets and interest rate liabilities. Both differ-
ences are identical in v alu e w hen total assets equ al total liabilities,
bu t w ill differ w hen the balance sheet is not balanced. This only
occu rs intra-day w hen, for ex am ple, a short position has y et to be
fu nded. The general m ark et practice is to calcu late the interest rate
gap as the difference betw een assets and liabilities. The gap is defi ned
in term s of the m atu rity period that has been specifi ed for it.
The conv ention u s ed to calcu late gaps is im portant for their
interpretation. A ‘fi x ed rate’ gap is the opposite of a ‘v ariable rate’
gap w hen assets and liabilities are equ al. They differ w hen assets and
liabilities do not m atch and there are m any reference rates. When
there is a defi cit, a ‘fi x ed rate gap’ is consis tent w ith the assu m ption
that it w ill be fu nded throu gh liabilities w hose rate is u nk now n. This
fu nding is then a v ariable rate liability and is the bank ’s risk , u nless
the rate has been lock ed in beforehand. The sam e assu m ption applies
w hen the bank ru ns a cash su rplu s position and the interest rate for
any period in the fu tu re is u nk now n. The gap position at a giv en tim e
bu ck et is sensitiv e to the interest rate that applies to that period.
The gap is calcu lated for each discrete tim e bu ck et, so there is a net
ex posu re for, say , 0–1 m onth, 1–3 m onths and so on. Loans and
deposits do not – ex cept at the tim e they are u ndertak en – hav e
su ch precise m atu rities, so they are ‘m apped’ to a tim e bu ck et in
term s of their relativ e w eighting. For ex am ple, a £100 m illion deposit
that m atu res in 20 day s’ tim e w ill hav e m ost of its balance m apped to
the 3-w eek tim e bu ck et, bu t a sm aller am ou nt w ill also be allocated
to the 2-w eek bu ck et. Interest rate risk is m easu red as the change in
present v alu e of the deposit at each grid point giv en a 1 bp change in
the interest rate. So, a £10 m illion 1-m onth CD that w as bou ght at
6.50% w ill hav e its present v alu e m ov e u pw ards if on the nex t day
the 1-m onth rate m ov es dow n by 1 bp.
The net change in present v alu e for a 1 bp m ov e is the k ey m easu re of
interest rate risk for a bank ing book ; this is w hat is u su ally referred to
as a ‘gap report’, althou gh strictly speak ing it is not. Su ch a report is
called a PVBP (present v alu e of a basis point) report or a DV01 (dollar
v alu e of a 01, or 1 bp) report. The calcu lation of interest rate sensi-
tiv ity assu m es a parallel shift in the y ield cu rv e – that is, that ev ery
m atu rity point along the term stru ctu re m ov es by the sam e am ou nt
(here 1 bp) and in the sam e direction. An ex am ple of a PVBP report is
giv en in Table 6.4, split by different cu rrency book s , bu t w ith all
v alu es conv erted to sterling.
The basic concept of a gap report is the net present v alu e (NPV) of
the bank ing book (introdu ced in Chapter 2). A PVBP report m easu res
the difference betw een the m ark et v alu es of assets and liabilities
in the bank ing book . To calcu late NPV w e requ ire a discou nt rate
w hich represents the mark to market of the book . The rates u sed are
alw ay s zero-cou pon rates deriv ed from the gov ernm ent bond y ield
cu rv e, althou gh som e adju stm ent shou ld be m ade to allow for
indiv idu al instru m ents.
Gaps m ay be calcu lated as differences betw een ou tstanding balances
at a giv en date, or as differences in the v ariation of those balances
ov er a tim e period. The gap nu m ber calcu lated from su ch v ariation is
k now n as a margin gap. Cu m u lativ e m argin gaps ov er a period of
tim e – plu s the initial difference in assets and liabilities at the
Table 6.4 Bank ing book PVBP grid report
12 m onths
2 m onths
3 m onths
6 m onths
1 m onth
1 w eek
2 y ears
1 day
GBP 8,395 6,431 9,927 8,856 (20,897) (115,303) (11,500) (237,658)

USD 1,796 (903) 10,502 12,941 16,784 17,308 (13,998) (18,768)
Eu ro 1,026 1,450 5,105 2,877 (24,433) (24,864) (17,980) (9,675)
Total 11,217 6,978 25,534 24,674 (28,546) (122,859) (43,478) (266,101)
10 y ears
15 y ears
20 y ears
30 y ears
3 y ears
4 y ears
5 y ears
7 y ears
GBP (349,876) (349,654) 5,398 (5,015) (25,334) (1,765) (31,243) (50,980)

USD (66,543) (9,876) (1,966) 237 2,320 (5,676) (1,121) 0
Eu ro (11,208) (3,076) 1,365 1,122 3,354 (545) (440) (52)
Total (427,627) (362,606) 4,797 (3,656) (19,660) (7,986) (32,804) (51,032)
GBP total (1,160,218)
USD total (56,963)
Eu ro total (75,974)
Grand total (1,293,155)
All fi gu res are in pou nds sterling.
beginning of the period – are identical to gaps betw een assets and
liabilities at the end of the period.
The interest rate gap differs from the liqu idity gap in a nu m ber of
w ay s:
only those assets and liabilities that hav e a fi x ed rate are u sed for
the interest rate gap, w hereas the liqu idity gap accou nts for all
assets and liabilities;
an interest rate gap cannot be calcu lated u nless a period has been
defi ned, becau se of the fi x ed-rate/v ariable-rate distinction – the
interest rate gap is dependent on a m atu rity period and an original
date.
The prim ary pu rpose in com piling the gap report is to determ ine
the sensitiv ity of the interest m argin to changes in interest rates.
Measu rem ent of the gap is alw ay s ‘behind the cu rv e’ as it is an

historical snapshot; the actu al gap is a dy nam ic v alu e as the
bank ing book continu ou sly u ndertak es day -to-day bu sines s.
Portfolio-m odified duration gap

Modifi ed du ration m easu res the change in m ark et price of a fi nancial
instru m ent that resu lts from a giv en change in m ark et interest rates.
The du ration gap of a net portfolio v alu e is a m easu re of the interest
rate sensitiv ity of a portfolio of fi nancial instru m ents and is the
difference betw een the w eighted av erage du ration of assets and
liabilities, adju sted for the net du ration of any off-balance-sheet
instru m ents . Hence, it m easu res the percentage change in net port-
folio v alu e that is ex pected to occu r if interest rates change by 1% .
Net portfolio v alu e, giv en by the NPV of the book , is the m ark et
v alu e of assets A m inu s the m ark et v alu e of liabilities L, plu s or
m inu s the m ark et v alu e OBS of off-balance-sheet instru m ents,
show n as:
NPV A L OBS 63
To calcu late the du ration gap of NPV, w e obtain the m odifi ed
du ration of each instru m ent in the portfolio and w eight this by
the ratio of its m ark et v alu e to the net v alu e of the portfolio.
This is done for assets, liabilities and off-balance-sheet instru m ents .
The m odifi ed du ration of the portfolio is:
MDNPV MDA MDL MDOBS 64
The m odifi ed du ration of NPV m ay be u sed to estim ate ex pected
change in the m ark et v alu e of the portfolio for a giv en change in
interest rates:
NPV NPV MD NPV r 65
It is often problem atic to obtain an accu rate v alu e for the m ark et
v alu e of ev ery instru m ent in a bank ing book . In practice, book v alu es
are often u sed to calcu late the du ration gap w hen m ark et v alu es are
not av ailable. This m ay resu lt in inaccu rate resu lts w hen actu al
m ark et v alu es differ from book v alu es by a m aterial am ou nt.
Other points to note abou t du ration gap analy sis are
The analy sis u ses m odifi ed du ration to calcu late the change in
NPV and therefore prov ides an accu rate estim ate of the price
sensitiv ity of instru m ents for only sm all changes in interest
rates. For a change in rates of m ore than, say , 50 basis points the
sensitiv ity m easu re giv en by m odifi ed du ration w ill be
signifi cantly incorrect.
Du ration gap analy sis, lik e the m atu rity gap m odel, assu m es
that interest rates change by m eans of parallel shift, w hich is
clearly u nrealistic.
As w ith m atu rity gap analy sis, the du ration gap is fav ou red in ALM
application becau se it is easily u nderstood and su m m arizes a
bank ing book ’s interest rate ex posu re in one conv enient nu m ber.
CRITIQUE OF THE
TRADITIONAL APPROACH
Traditionally , the m ain approach of ALM concentrates on the
interest sensitiv ity and net present v alu e sensitiv ity of a bank ’s
loan/deposit book . The u su al interest sensitiv ity report is the
m atu rity gap report, w hich w e rev iew ed briefl y earlier. How ev er,
the m atu rity gap report is not perfect and can be said to hav e the
follow ing draw back s:
The repricing interv als chosen for gap analy sis are u ltim ately
arbitrary , and there m ay be signifi cant m is m atches w ithin a
repricing interv al. For instance, a com m on repricing interv al is
the 1-y ear gap and the 1-to-3-y ear gap; there are (albeit ex trem e)
circu m stances w hen m ism atches w ou ld go u ndetected by the
m odel. Consider a bank ing book that is com posed solely of
liabilities that reprice in 1 m onth’ s tim e, and an equ al cash
v alu e of assets that reprice in 11 m onths’ tim e. The 1-y ear gap
of the book (assu m ing no other positions) w ou ld be zero, im ply -
ing no risk to net interest incom e. In fact, u nder ou r scenario net
interest incom e is signifi cantly at risk from a rise in interest
rates.
Matu rity gap m odels assu m e that interest rates change by a
u niform m agnitu de and direction. How ev er, for any giv en
change in the general lev el of interest rates it is m ore realistic
for different m atu rity interest rates to change by different
am ou nts – this is k now n as non-parallel shift.
Matu rity gap m odels assu m e that principal cashfl ow s do not
change w hen interest rates change. Therefore, it is not possible
to incorporate the im pact of options em bedded in certain fi nan-
cial instru m ents effectiv ely . Instru m ents su ch as m ortgage-
back ed bonds and conv ertibles do not fall accu rately into gap
analy sis, as only their fi rst-order risk ex posu re is captu red.
Notw ithstanding these draw back s, the gap m odel is w idely u sed, as
it is easily u nderstood in the com m ercial bank ing and m ortgage
indu stry ; m oreov er, its application does not requ ire a k now ledge
of sophisticated fi nancial m odelling techniqu es.
The cost of funding

Bank s can choose to set u p their Treasu ry fu nction as either a cost
centre or a profi t centre. Most of the discu ssion u p to now has
assu m ed a profi t centre arrangem ent, w ith the Treasu ry desk re-
sponsible for the m ark et-m ak ing of m oney m ark et instru m ents
and for positioning the bank ’s ALM requ irem ent and trade m oney
m ark ets to profi t. Som e institu tions set the Treasu ry fu nction u p
sim ply to arrange the fi rm ’ s fu nding requ irem ent su ch that it is not
ex pected to generate profi t.
In su ch an arrangem ent, the qu estion arises as to w hat the Treasu ry
desk shou ld charge the fi rm ’s lines of bu s iness for their fu nds.
Consider a brok er-dealer fi rm that operated the follow ing lines of
bu s iness:
a corporate bond m ark et-m ak ing desk ;
an equ ity deriv ativ es trading desk ;
an inv estm ent portfolio that holds ABS, MBS and CDO secu rities
for the m ediu m term ;
a bu s iness that offers stru ctu red deriv ativ es produ cts, on a
lev eraged basis, to clients that w ish to inv est in a hedge fu nd
of fu nds.
Each of these lines of bu sines s w ill hav e a different fu nding
requ irem ent; for ex am ple, the m ark et-m ak ing desk w ou ld ex pect
to hav e a frequ ent tu rnov er of its portfolio and so its liqu idity
profi le w ou ld be fairly short dated. It cou ld be fu nded u sing short-
term borrow ing – no m ore than 1 w eek to 1 m onth – w ith m u ch
fu nding on an ov ernight to 1-w eek basis . The client bu sines s w ou ld
hav e a longer dated asset profi le, and so shou ld really be fu nded u sing
a m ix tu re of short-dated, m ediu m -dated and long-dated fu nds.
Ass u m ing a positiv e-sloping y ield cu rv e, the term stru ctu re effect
m eans that the client bu s iness w ou ld hav e a higher cost of fu nds.
How ev er, the Treasu ry desk w ou ld not fu nd each desk separately – it
cou ld, bu t that w ou ld be ineffi cient and w astefu l of resou rces. So,
w hat charge shou ld be m ade to the desk s for their fu nds?
In practice, bank s u se either a w eighted av erage cost of fu nds –
som etim es called a ‘blended’ or ‘pooled’ rate – w hich is passed on
to the w hole fi rm , or they apply a form of internal fu nds pricing –
som etim es called ‘transfer pricing’ or ‘transfer liqu idity pricing’
(TLP) – in w hich a spread is added to the Libor-based fu nding
cost, determ ined by the ex tent of liqu idity stress pu t onto the
bank ’s balance sheet by the indiv idu al bu s iness line. This is
discu s sed fu rther in Chapter 8.
The cost of borrowing

There are tw o approaches to ascertaining the transfer price for loans.
The fi rst approach refers to ex isting assets and liabilities, and charges
a cost for each loan as a proportion of the total. The second, and m ore
com m on approach, is to defi ne an optim u m fu nding solu tion and u se
this as the cost of fu nds. In practice, this w ill be the blended rate.
Using ex isting resou rces has the appeal of sim plicity . How ev er,
it raises the problem s w e encou ntered at the start of this section;
each ty pe of resou rce has a different cost. We cou ld defi ne a m atu rity
term for all assets and m atch each term loan to assets of identical
m atu rity . Bu t this is not effectiv e in practice. For instance, if an asset
can be identifi ed that has a precis e m atu rity profi le, then one can
fu nd it to m atching dates either w ith one loan or a set of loans that all
roll off in sequ ence u ntil the fi nal m atu rity date. To do this for ev ery
asset w ou ld be im practical, how ev er.
Hence, a ‘w eighted av erage cost of capital’ (WACC) is u sed.
The blended cost of funds

For fi x ed rate loans the cost of fu nds is ex plicit, bu t w hen m ore than
one loan is tak en ou t the fu nding cost w ill depend on the com bina-
tion of am ou nts borrow ed and their respectiv e m atu rity dates.
For instance, consider a fu nding arrangem ent for USD100 that is
com prised of:
USD40 borrow ed for 2 y ears;
USD60 borrow ed for 1 y ear.
The relev ant interest rates are the zero-cou pon interest rates for
1-y ear and 2-y ear loans. The transfer price to u se for ov erall
fu nding of 100 in the fi rst 12 m onths is the av erage cost of the fu nds
of these tw o loans. It is in fact giv en by the discou nt rate that w ou ld
equ ate the present v alu e of the fu tu re v alu es of each loan to the
original am ou nt borrow ed. The fu tu re v alu e is of cou rse the m atu rity
am ou nt, w hich is the original principal plu s interest. To be strictly
accu rate, w e assu m e that the loans are zero-cou pon loans and the
interest rates charged are zero-cou pon interest rates.
Fu tu re cashfl ow s on the abov e arrangem ent are:
60 1 r1 in Year 1, and
40 1 r2 2 in Year 1 and Year 2.
So, WACC is giv en by the rate rw su ch that
2 2
100 60 1 r1 1 rw 40 1 r2 1 rw
This discou nt rate w ill obv iou sly lie som ew here betw een r1 and r2 .
A ‘back of the env elope’ solu tion cou ld be done by calcu lating the
linear approx im ation of the abov e form u la, nam ely
100 60 1 r1 rw 40 1 2r2 2rw
rw 60 r1 40 2 r2 60 2 40
The rate rw is the w eighted av erage of the tw o rates r1 and r2 , w hich
w e took to be the 1-y ear and 2-y ear zero-cou pon rates, respectiv ely .
The w eighting u sed refers to the size of the loan in proportion to the
total and its m atu rity . As a rou gh ru le of thu m b, a 1-y ear rate rolled
ov er in a 2-y ear period w ou ld be w eighed at tw ice the 2-y ear rate. If w e
im agine that r1 is 4.00% and r2 is 5.00% , then rw in this case w ill be
nearer to r2 , becau se it is the longest dated loan, bu t the fact that the
1-y ear loan in ou r ex am ple w as for a larger su m com pensates for this.
In practice, ev en v ery large com m ercial bank s and inv estm ent bank s
calcu late their WACC as the su m of daily interest pay m ents on ev ery
loan ou tstanding div ided by the total nom inal am ou nt of all loans.
We illu strate the concept of WACC in a practical fashion in Figu re
6.7. This show s a USD500 m illion fu nding requ irem ent that has
been arranged as three loans, nam ely ,
ov ernight loan of USD200 m illion at 1.05% ;
1-w eek loan of USD200 m illion at 1.07% ;
3-m onth loan of USD100 m illion at 1.15% .
The spreadsheet show s the calcu lation of WACC on a m ore
scientifi c basis than the ‘back of the env elope’ approach, as it
tak es into accou nt the term stru ctu re effect of the loans (as w e go
Figure 6.7 USD500 m illion fu nding requ irem ent that has been arranged
as three loans.
fu rther ou t along the term stru ctu re, w e pay a higher rate of interest).
How ev er, the resu lt is v ery close to the sim ple approach. The WACC
for these three loans is show n to be 1.146% .
We repeat the spreadsheet at Figu re 6.8 w ith the form u lae u sed in
each cell show n instead of the v alu e.
SECURITIZATION
It is com m on for the ALM u nits in bank s to tak e responsibility for a
m ore proactiv e balance sheet m anagem ent role; securitization is a
good ex am ple of this. Secu ritization is a process u ndertak en by bank s
to both realize additional v alu e from assets held on the balance sheet
and to rem ov e them from the balance sheet entirely , thu s freeing u p
lending lines. Essentially , it inv olv es selling assets on the balance

sheet to third-party inv estors. In principle, the process is straightfor-
w ard, as assets that are sold generate cashfl ow s in the fu tu re, w hich
prov ides retu rn to inv estors w ho hav e pu rchased the secu ritized
assets. To control risk ex posu re for inv estors, the u ncertainty asso-
ciated w ith certain asset cashfl ow s is controlled or re-engineered –
there are a range of w ay s in w hich this m ay be done.
For balance sheet m anagem ent one of the principal benefi ts of
secu ritisation is to sav e or redu ce capital charges by the sale of
assets. The other added benefi t, of cou rse, is that the process
generates additional retu rn for the issu ing bank ; therefore, secu riti-
zation is not only a m ethod by w hich capital charges m ay be sav ed,
bu t an instru m ent in its ow n right that enables a bank to increase its
retu rn on capital.
Figure 6.8 Form u lae u sed to calcu late the USD500 m illion fu nding requ ire-
m ent that has been arranged as three loans.
The securitization process

For an introdu ction to asset-back ed instru m ents see Fabozzi and
Chou dhry (2004). In this section w e consider the im plications of
secu ritization from the point of v iew of asset and liability m anage-
m ent. The su bject is considered in greater detail in Chou dhry (2007).
The basic principle of secu ritization is to sell assets to inv estors –

u su ally throu gh a m ediu m k now n as a special purpose vehicle or
som e other interm ediate stru ctu re – and to prov ide inv estors w ith a
fi x ed or fl oating rate retu rn on the assets they hav e pu rchased; the
cashfl ow s from the original assets are u sed to prov ide this retu rn. It is
rare, thou gh not totally u nk now n, for inv estors to bu y the assets
directly ; to av oid this, a class of secu rities is created to represent the
assets and inv estors then pu rchase these secu rities. The m ost
com m on ty pes of assets secu ritized inclu de m ortgages, car loans
and credit card loans. How ev er, in theory , v irtu ally any asset that
generates a cashfl ow that can be predicted or m odelled m ay be
secu ritized. The v ehicle u sed is constru cted su ch that secu rities
issu ed against the asset base hav e a risk retu rn profi le that is
attractiv e to the inv estors being targeted.
To benefi t from div ersifi cation, asset ty pes are u su ally pooled and
this pool then generates a range of interest pay m ents , principal
repay m ents and principal prepay m ents . The precis e natu re of cash-
fl ow s is u nclear not only becau se of the u ncertainty of pay m ent and
prepay m ent patterns, bu t also becau se of the occu rrence of loan
defau lts and delay s in pay m ent. How ev er, pooling of a large
nu m ber of loans m eans that cashfl ow fl u ctu ation can be ironed ou t

to a large ex tent, su ffi cient to issu e notes against. The cashfl ow s
generated by the pool of assets are re-rou ted to inv estors by m eans of
a dedicated stru ctu re, and a credit rating for the issu e is u su ally
requ ested from one or m ore priv ate credit agencies. Most asset-
back ed secu rities carry inv estm ent-grade credit ratings – often
triple A or dou ble A – m ainly becau se of v ariou s credit insu rance
facilities that are set u p to gu arantee the bonds. The secu ritization
stru ctu re disas sociates the qu ality of original cashfl ow s from that of
fl ow s accru ing to inv estors. In m any cases, original borrow ers are not
aw are that the process has occu rred and notice no difference in the
w ay their loan is handled. The credit rating on the secu ritization
issu e has no bearing on the rating of the selling bank and often w ill be
different.
Benefits of securitization
Secu ritizing assets produ ces a dou ble benefi t for the issu ing bank .
Ass ets that are sold to inv estors generate a sav ing in the cost of
requ ired capital for the bank , as they are no longer on the balance
sheet, so the bank ’s capital requ irem ent is redu ced. Second, if the
credit rating of the issu ed secu rities is higher than that of the
originating bank , there is a potential gain in the fu nding costs of
the bank . For ex am ple, if the secu rities issu ed are triple A rated, a
dou ble-A-rated bank w ill hav e low er fu nding costs for those secu r-
ities. The bank benefi ts from pay ing a low er rate on the borrow ed
fu nds than if it had borrow ed those fu nds directly in the m ark et. This
has led to strong grow th in, for ex am ple, the specialized ‘credit card’
bank s in the US, w here bank s su ch as Capital One, First USA and
MBNA Bank hav e benefi ted from triple-A-rated fu nding lev els and
low capital charges. It is dou btfu l w hether su ch bank s cou ld hav e
grow n as rapidly as they did w ithou t secu ritization. Althou gh there
is a cost associated w ith secu ritizing assets – w hich inclu de direct
issu e transaction costs and the cost of ru nning the pay m ent stru ctu re
– these are ou tw eighed by the benefi ts obtained from the process.
The m ajor benefi t of secu ritization is redu ced fu nding costs. Sev eral
factors infl u ence su ch costs. These inclu de
Low er cost of fu nds du e to the enhanced credit rating of the bonds
issu ed. The ex tent of this gain is a fu nction of cu rrent spreads in
the m ark et and the cu rrent rating of the originating bank . It w ill
fl u ctu ate in line w ith m ark et conditions.
Sav ing the capital charges that resu lt from redu cing the size of
assets on the balance sheet. This decreases the m inim u m earn-
ings requ ired to ensu re adequ ate retu rn for shareholders, in effect
im prov ing retu rn on capital at a strok e.
The costs of the process inclu de
Costs associated w ith setting u p the issu ing stru ctu re and,
su bsequ ently , the pay m ent m echanism that channels cashfl ow s
to inv estors. Thes e costs are a fu nction of the stru ctu re and risk of
the original assets; the higher the risk of the original assets, the
higher the cost of ensu ring cashfl ow s for inv estors.
The legal costs of origination, plu s operating costs and serv icing
costs.
How ev er, the redu ction in fu nding cost obtained as a resu lt of
secu ritization shou ld signifi cantly ou tw eigh the cost of the
process itself. In order to determ ine w hether secu ritization is feas-
ible, as w ell as how it im pacts retu rn on capital, the originating bank
w ill condu ct a cost-and-benefi t analy sis prior to em bark ing on the
process. This is frequ ently the responsibility of the ALM u nit.
Example 6.1 Secu ritization transaction
We illu strate the im pact of secu ritizing the balance sheet by an

ex am ple from ou r hy pothetical bank – ABC Bank plc.
The bank has a m ortgage book of £100 m illion; the regu latory
w eight for this asset is 50% . The capital requ irem ent is therefore
£4 m illion – that is, 8% 0.5% £100 m illion. The capital is
com prised of equ ity (estim ated to cost 25% ) and su bordinated debt
(w hich has a cost of 10.2% ). The cost of straight debt is 10% . The
ALM desk rev iew s a secu ritization of 10% of the asset book , or £10
m illion. The loan book has a fi x ed du ration of 20 y ears, bu t its
effectiv e du ration is estim ated at 7 y ears, du e to refi nancings and
early repay m ents. Net retu rn from the loan book is 10.2% .
The ALM desk decides on a secu ritized stru ctu re that is m ade u p of
tw o classes of secu rity : su bordinated notes and senior notes.
Su bordinated notes w ill be granted a single A rating du e to their
higher risk , w hile senior notes are rated triple A. Giv en su ch
ratings the requ ired rate of retu rn for su bordinated notes is 10.61%
and that of senior notes is 9.80% . Senior notes hav e a low er
costthan cu rrent balance sheet debt, w hich has a cost of 10% . To
Table 6.5 ABC Bank plc m ortgage loan

book and secu ritization proposal
C urrent funding
Cost of equ ity 25%
Cost of su bordinated debt 10.20%
Cost of debt 10%
Mortgage book
Net y ield 10.20%
Du ration 7 y ears
Balance ou tstanding 100 m illion
Proposed structure
Secu ritized am ou nt 10 m illion
Senior secu rities:
Cost 9.80%
Weighting 90%
Matu rity 10 y ears
Su bordinated notes:
Cost 10.61%
Weighting 10%
Matu rity 10 y ears
Serv icing costs 0.20%
obtain a single A rating, su bordinated notes need to represent at

least 10% of the secu ritized am ou nt. The costs associated w ith the
transaction are the initial cost of issu e and the y early serv icing
cost, estim ated at 0.20% of the secu ritized am ou nt. Su m m ary
inform ation is giv en in Table 6.5.
A bank ’s cost of fu nding is the av erage cost of all fu nds em ploy ed.
The fu nding stru ctu re in ou r ex am ple is capital 4% – w hich is
fu rther split u p as 2% equ ity at 25% , 2% su bordinated debt at
10.20% and 96% debt at 10% . The w eighted fu nding cost F
therefore is:
Fbalance sheet 96% 10%
8% 50% 25% 50% 10 20% 50%
10 30%
This av erage rate is consistent w ith the 25% before-tax retu rn on
equ ity giv en at the start. If the assets do not generate this retu rn,
the retu rn receiv ed w ill change accordingly , since it is the end

resu lt of the bank ’s profi tability . As the assets only generate
10.20% , they are cu rrently perform ing below shareholder ex pecta-
tions. The retu rn actu ally obtained by shareholders is su ch that
the av erage cost of fu nds is identical to the 10.20% retu rn on
assets. We m ay calcu late this retu rn to be:
Asset retu rn 10 20%
96% 10%
8% 50% ROE 50% 10 20% 50%

Solv ing this relationship w e obtain a retu rn on equ ity (ROE) of
19.80% , w hich is low er than shareholder ex pectations. In theory ,
the bank w ou ld fi nd it im pos sible to raise new equ ity in the
m ark et becau se its perform ance w ou ld not com pensate share-
holders for the risk they are incu rring by holding the bank ’s paper.
Therefore, any asset that is originated by the bank w ou ld not only
hav e to be secu ritized, bu t also be ex pected to raise shareholder
retu rn.
The ALM desk proceeds w ith secu ritization, issu ing £9 m illion in
senior secu rities and £1 m illion in su bordinated notes. The bonds
are placed by an inv estm ent bank w ith institu tional inv estors.
The ou tstanding balance of the loan book decreases from £100
m illion to £90 m illion. Weighted assets are therefore £45 m illion.
Therefore, the capital requ irem ent for the loan book is now £3.6
m illion, a redu ction from the original capital requ irem ent of
£400,000, w hich can be u sed for ex pansion in another area (see
Table 6.6).
Table 6.6 Im pact of secu ritization on balance sheet
Outstanding balances Value (£m ) Capital required (£m )
Initial loan book 100 4

Secu ritized am ou nt 10 0.4
Senior secu rities 9 Sold
Su bordinated notes 1 Sold
New loan book 90 3.6
Total asset 90
Total weighted assets 45 3.6
The benefi t of secu ritization is redu ction in the cost of fu nding.

Fu nding cost as a resu lt of secu ritization is the w eighted cost of
senior notes and su bordinated notes, together w ith the annu al
serv icing cost. The cost of senior secu rities is 9.80% , w hile
su bordinated notes hav e a cost of 10.61% (for sim plicity w e
ignore any differences in the du ration and am ortization profi les
of the tw o bonds). This is calcu lated as:
90% 9 80% 10% 10 61% 0 20% 10 08%
This ov erall cost is low er than the target fu nding cost obtained
directly from the balance sheet, w hich w as 10.30% . This is the
qu antifi ed benefi t of the secu ritization process. Note that the
fu nding cost obtained throu gh secu ritization is low er than
the y ield on the loan book . Therefore, the original loan can be
sold to the stru ctu re issu ing the secu rities for a gain.
Example 6.2 Position m anagem ent
Starting the day w ith a fl at position, a m oney m ark et interbank

desk transacts the follow ing deals:
1. £100 m illion borrow ing from 16/9/09 to 7/10/09 (3 w eek s) at
6.375% .
2. £60 m illion borrow ing from 16/9/09 to 16/10/09 (1 m onth) at
6.25% .
3. £110 m illion loan from 16/9/09 to 18/10/09 (32 day s) at 6.45% .
The desk rev iew s its cash position and the im plications for
refu nding and interest rate risk , bearing in m ind the follow ing:
There is an internal ov ernight rollov er lim it of £40 m illion
(net).
The bank ’s econom ist feels m ore pessim is tic abou t a rise in
interest rates than m ost others in the m ark et, and has recently
giv en an internal sem inar on the dangers of infl ation in the UK
as a resu lt of recent increases in the lev el of av erage earnings.
Today , som e im portant fi gu res are being released inclu ding
infl ation (RPI) data. If today ’s RPI fi gu res ex ceed m ark et
ex pectations, the dealer ex pects a tightening of m onetary
policy by at least 0.50% alm os t im m ediately .
Brok ers estim ate daily m ark et liqu idity for the nex t few w eek s
to be one of low shortage, w ith little central bank interv ention
requ ired, and hence low v olatilities and low rates in the
ov ernight rate.
Brok ers’ screens indicate the follow ing term repo rates:
O/N 6.350% –6.300%
1 w eek 6.390% –6.340%
2 w eek 6.400% –6.350%
1 m onth 6.410% –6.375%
2 m onth 6.500% –6.450%
3 m onth 6.670% –6.620% .
The indication for a 1v 2 FRA is:
1v 2 FRA 6.680% –6.630% .
The qu ote for an 11-day forw ard borrow ing in 3 w eek s’ tim e
(the ‘21v 32 rate’) is 6.50% bid.
The book ’s ex posu re look s lik e this:
16 Septem ber 7 October 16 October 18 October

Long £50m Short £50m Short £110m Flat
What cou rses of action are open to the desk , bearing in m ind that
the book needs to be squ ared off su ch that the position is fl at each
night?
Possible solutions
Investing early surplus
From a cash m anagem ent point of v iew , the desk has a £50 m illion
su rplu s from 16/9 u p to 7/10. This needs to be inv ested. It m ay be
able to negotiate a 6.31% loan w ith the m ark et for ov ernight, or a
6.35% term deposit for 1 w eek or 6.38% for 1 m onth.
An ov ernight roll is the m ost fl ex ible bu t offers the w orst rate. If the
desk ex pects the ov ernight rate to rem ain both low and stable (du e
to forecasts of low m ark et shortages), it m ay not opt for this cou rse
of action.
How ev er, it m ay m ak e sense from an interest rate risk point of
v iew . If the desk agrees w ith the bank ’s econom ist, it shou ld be
able to benefi t from rolling at higher rates soon – possibly in the
nex t 3 w eek s. Therefore, it m ay not w ant to lock in a term rate
now , and the ov ernight roll w ou ld m atch this v iew . How ev er, it
ex poses them to low er rates, if their v iew is w rong, w hich w ill
lim it the ex tent of the positiv e fu nding spread. The m ark et itself
appears neu tral abou t rate changes in the nex t m onth, bu t appears
to factor in a rise thereafter.
The forward ‘gap’

Look ing forw ard, the book is cu rrently on cou rse to ex ceed the £40
m illion ov ernight position lim it on 7/10, w hen the refu nding
requ irem ent is £50 m illion. The situ ation gets w orse on 16/10
(for 2 day s) w hen the refu nding requ irem ent is £110 m illion. The
desk needs to fi x a term deal before those dates to carry it ov er u ntil
18/10 w hen the fu nding position rev erts to zero. A borrow ing from
7/10 to 18/10 of £50 m illion w ill bring the rollov er requ irem ent
back to w ithin lim its .
How ev er, giv en that interest rates w ill rise, shou ld the desk w ait
u ntil the 7th to deal in the cash? Not if it has a fi rm v iew . It m ay
end u p pay ing as m u ch as 6.91% or higher for the fu nding (after the
0.50% rate rise). So, it w ou ld be better to transact a forw ard-
starting repo now to cov er the period, thu s lock ing in the benefi ts
obtainable from today ’s y ield cu rv e. The m ark et rate for a 21 32-
day repo is qu oted at 6.50% . This refl ects the m ark et’s consensu s
that rates m ay rise in abou t a m onth’s tim e. How ev er, the desk ’s
ow n ex pectation is of a larger rise – hence, its ow n logic su ggests
trading in the forw ard loan. This strategy w ill pay div idends if its
v iew is right, as it lim its the ex tent of fu nding loss.
An alternativ e m eans of protecting interest rate risk is to bu y a
1v 2-m onth FRA for 6.68% . This does not ex actly m atch the gap,
bu t shou ld act as an effectiv e hedge. If there is a rate rise, the book
gains from the FRA profi t. Note that the cash position still needs to
be squ ared off. Shou ld the desk deal before or after the infl ation
annou ncem ent? That is, of cou rse, dow n to its ow n intu ition, bu t
m ost dealers lik e to sit tight ahead of releases of k ey econom ic
data, if at all possible.
Generic ALM policy for different-sized bank s

The m anagem ent of interest rate risk is a fu ndam ental ingredient of
com m ercial bank ing. Bank shareholders tak e com fort from interest
rate risk being m easu red and m anaged satisfactorily . A com m on
approach to risk m anagem ent inv olv es the follow ing:
Preparation and adoption of a high-lev el interest rate risk policy

at board lev el. This sets general gu idelines on the ty pe and
ex tent of risk ex posu re that can be tak en on by the bank .
Setting lim its on the risk ex posu re lev els of the bank ing book .
This can be by produ ct ty pe, desk , geographic area and so on, and
w ill be along the m atu rity spectru m .
Activ ely m easu ring the lev el of interest rate risk ex posu re at
regu lar, specifi ed interv als.
Reporting to senior m anagem ent on general aspects of risk
m anagem ent, risk ex posu re lev els, lim it breaches and so on.
Monitoring risk m anagem ent policies and procedu res by an
independent ‘m iddle offi ce’ risk fu nction.
The risk m anagem ent approach adopted by bank s w ill v ary according
to their specifi c m ark ets and appetite for risk . Certain institu tions
hav e their activ ities set ou t or prescribed for them u nder regu latory
ru les . For instance, bu ilding societies in the UK are prohibited from
trading in certain instru m ents by the regu lator. In this section w e
present for illu strativ e pu rposes the ALM policies of three hy po-
thetical bank s: Bank S, Bank M and Bank L. Thes e bank s are,
respectiv ely , a sm all bank ing entity w ith assets of £500 m illion, a
m ediu m -sized bank w ith assets of £2.5 billion and a large bank w ith
assets of £10 billion. In the follow ing w e dem onstrate the differing
approaches that can be tak en according to the env ironm ent that a
fi nancial institu tion operates in.
ALM policy for Bank S (assets £500 million)

The aim of the ALM policy for Bank S is to prov ide gu idelines on risk
appetite, rev enu e targets and rates of retu rn, in addition to prov iding
a risk m anagem ent policy . Areas that m ay be cov ered inclu de capital
ratios, liqu idity , asset m ix , rate-setting policy for loans and deposits,
as w ell as inv estm ent gu idelines for the bank ing portfolio. The k ey
objectiv es shou ld inclu de
m aintaining capital ratios at the planned m inim u m and ensu ring
the safety of the deposit base;
generating a satisfactory rev enu e stream , both for incom e
pu rposes and to fu rther protect the deposit base.
The responsibility for ov erseeing the operations of the bank to ensu re
that these objectiv es are achiev ed is lodged w ith the ALCO. This
body m onitors the v olu m e and m ix of the bank ’s assets and fu nding
(liabilities), and ensu res that this asset m ix follow s internal gu ide-
lines w ith regard to bank ing liqu idity , capital adequ acy , asset base
grow th targets, risk ex posu re and retu rn on capital. The norm is for
the com m ittee to m eet on a m onthly basis ; m em bership of the
com m ittee w ill inclu de the fi nance director, the head of Treasu ry
and the risk m anager at the v ery least. For a bank the size of Bank S
the ALCO m em bership w ill possibly be ex tended to the chief
ex ecu tiv e, the head of the loans bu sines s and the chief operating
offi cer.
As a m atter of cou rse the com m ittee w ill w is h to discu ss and rev iew
the follow ing on a regu lar basis:
Ov erall m acroeconom ic conditions.

Financial resu lts and k ey m anagem ent ratios – su ch as share price
analy sis and rates of retu rn on capital and equ ity .
Hou se v iew on the lik ely direction of short-term interest rates.
Cu rrent lending strategy – and any su ggestions for changes – and
cu rrent fu nding strategy .
Anticipated changes to the v olu m e and m ix of the loan book , and
to that of the m ain sou rces of fu nding.
Appropriateness or otherw ise of alternativ e sou rces of fu nding.
Su ggestions for any alterations to the bank ’s ALM policy .
Matu rity gap profi le as w ell as anticipated and su ggested changes
to it.
The com m ittee w ill also w ish to consider interest rates cu rrently
offered on loans and deposits, and w hether they are still appropriate.
Interest rate sensitiv ity is m onitored and confi rm ed as ly ing w ithin

specifi ed param eters; these param eters are regu larly rev iew ed and
adju sted if deem ed necessary according to changes in the bu sines s
cy cle and econom ic conditions. Interest rate sensitiv ity is m easu red
u sing the follow ing ratio:
A ir L ir
Ty pical risk lev els w ou ld be ex pected to lie betw een 90% and 120%
for the m atu rity period 0–90 day s, and betw een 80% and 110% for
the m atu rity period ov er 90 day s bu t less than 365 day s.
Pu t sim ply , the objectiv e of Bank S is to rem ain w ithin specifi ed risk
param eters at all tim es, and to m aintain as consistent a lev el of
earnings as possible (and one that is im m u ne to changes in the
bu s iness cy cle).
ALM policy for Bank M (assets £2.5 billion)

Bank M is ou r hy pothetical ‘m ediu m -sized’ bank ing institu tion.
Its ALM policy w ou ld be ov erseen by the ALCO. Ty pically , the
com m ittee w ou ld consist of the follow ing m em bers of senior
m anagem ent:
depu ty chief ex ecu tiv e
fi nance director
head of retail bank ing
head of corporate bank ing
head of Treasu ry
head of risk m anagem ent
head of internal au dit.
Others – su ch as produ ct specialists – w ou ld be called to attend as and
w hen requ ired. The fi nance director often chairs the m eeting.
The prim ary responsibilities of the ALCO are detailed below .
Objectives
The ALCO is task ed w ith rev iew ing the bank ’s ov erall fu nding
strategy . Decisions tak en are recorded in the m inu tes and circu lated
to attendees and designated k ey staff. ALCO m em bers are
responsible for u ndertak ing regu lar rev iew s of the follow ing:
m inu tes of the prev iou s m eeting;
the ratio of interest-rate-sensitiv e assets to liabilities, gap reports ,
risk reports and the fu nding position;
the bank ’s v iew on the ex pected lev el of interest rates and how
the book shou ld be positioned in light of this;
the ALCO v iew on anticipated fu nding costs in the short term
and m ediu m term – this is closely related to the prev iou s item ;
stress-testing in the form of ‘w hat if?’ scenarios, to check the
effect on the bank ing book of specifi ed changes in m ark et
conditions;
change in param eters that m ay be requ ired if there is a change in
m ark et conditions or risk tolerance;
cu rrent interest rates for loans and deposits, to ensu re that they
are in accordance w ith the ov erall lending and fu nding strategy ;
m atu rity distribu tion of the liqu idity book (ex pected to be com -
prised of T-bills, CDs and v ery short-dated gov ernm ent bonds );
cu rrent liqu idity position and ex pected position in the short term
and m ediu m term .
As the ALCO m eets on a regu lar m onthly basis , it is u su al for only a

few of these aspects to be discu s sed at ev ery m eeting; the agenda is
set by the chair of the m eeting in consu ltation w ith com m ittee
m em bers. The policies adopted by the ALCO shou ld be dy nam ic
and fl ex ible, and capable of adaptation to changes in operating con-
ditions. Any changes to policy can only be m ade by the com m ittee
itself and any ex ceptions to agreed policy can only be m ade w ith the
approv al of the CEO or the ALCO itself.
Interest rate risk policy

The objectiv e w ill be to k eep earnings v olatility resu lting from an
u pw ard or dow nw ard m ov e in interest rates to a m inim u m . To this
end, at each ALCO m eeting m em bers w ill rev iew risk and position
reports and discu s s them in light of the risk policy . Generally , the
6-m onth and 12-m onth A ir L ir cu m u lativ e ratio w ill lie in the range
90% to 110% . A signifi cant m ov e ou tside this range w ill m ost lik ely
be su bject to correctiv e action. The com m ittee w ill also consider the
resu lts of v ariou s scenario analy ses on the book , and if these tests
indicate a potential earnings im pact of greater than, say , 10% ,
instru ctions m ay be giv en to alter the shape and m atu rity profi le
of the book .
Liquidity policy
A prim ary responsibility of the ALCO is to ensu re that an adequ ate
lev el of liqu idity is m aintained at all tim es. Gu p and Brook s (1993,
p. 238) defi ne liqu idity as
‘ the ability to m eet anticipated and u nanticipated operating
cash needs, loan dem and, and deposit w ithdraw als, w ithou t
incu rring a su stained negativ e im pact on profi tability .’
Generally , a Bank -M-ty pe operation w ou ld ex pect to hav e a target
lev el for loans to deposits of arou nd 75% to 85% , and a loans-to-core-
deposits ratio of 85% to 95% . The loan/depos it ratio is reported to
the ALCO and rev iew ed on a m onthly basis, and any reported fi gu re
signifi cantly ou tside these ranges (say , by 5% or m ore) w ill be
rev iew ed and ask ed to be adju sted to bring it back into line w ith
ALCO policy .
ALM policy for Bank L (assets £10 billion)

The policy for ALM at a larger entity w ill bu ild on that described for a
m ediu m -sized fi nancial institu tion. If Bank L is a grou p com pany ,

the policy w ill cov er the consolidated balance sheet as w ell as
indiv idu al su bsidiary balance sheets; the com m ittee w ill prov ide
direction on the m anagem ent of assets and liabilities as w ell as
on the off-balance-sheet instru m ents u sed to m anage interest rate
and credit risk . A w ell-fu nctioning m anagem ent process w ill be
proactiv e and concentrate on direction in response to anticipated
changes in operating conditions, rather than reactiv e responses to
changes that hav e already tak en place. Prim ary objectiv es w ill be
to m ax im ize shareholder v alu e, w ith target retu rns on capital of 15%
to 22% .
The responsibility for im plem enting and ov erseeing ALM policy w ill
reside w ith the ALCO. The com m ittee w ill establish operating
gu idelines for ALM and rev iew them periodically . It w ill m eet on
a m ore frequ ent basis than is the case for Bank M – u su ally fort-
nightly . In addition to this, it w ill set policies gov erning liqu idity
and fu nding objectiv es, inv estm ent activ ities and interest rate risk .
It w ill also ov ersee the activ ities of the inv estm ent-bank ing div ision.
The head of the ALM desk w ill prepare the interest rate risk
sensitiv ity report and present it to the ALCO.
Interest rate risk management

The ALCO w ill establish an interest rate risk policy that sets the
direction for acceptable lev els of interest rate risk . This risk policy is
designed to help m anagem ent ev alu ate the im pact of interest rate
risk on the bank ’s earnings. The ex tent of risk ex posu re is a fu nction
of the m atu rity profi le of the balance sheet, as w ell as the frequ ency
of repricing, the lev el of loan prepay m ents and fu nding costs. Manag-
ing interest rate risk is, in effect, the adju stm ent of risk ex posu re
u pw ards or dow nw ards in response to the ALCO’s v iew s on the
fu tu re direction of interest rates. As part of the risk m anagem ent
process the com m ittee w ill m onitor cu rrent risk ex posu re and
the du ration gap, u sing rate sensitiv ity analy sis and sim u lation
m odelling to asses s w hether the cu rrent lev el of risk is satisfactory .
Measuring interest rate risk

Notw ithstanding the w idespread adoption of v alu e-at-risk as the k ey
m ark et risk m easu rem ent tool, fu nding book s su ch as repo book s
continu e to u s e the gap report as a k ey m easu re of interest rate risk
ex posu re. This enables the ALCO to v iew risk sensitiv ity along the
m atu rity stru ctu re. Cu m u lativ e gap positions and the ratio of asset
rev alu ation to liability rev alu ation are calcu lated and com pared w ith
earnings lev els on the cu rrent asset/liability position. Generally , the
90-day , 6-m onth and 1-y ear gap positions are the m ost signifi cant
points along the term stru ctu re at w hich interest rate risk ex posu re is
calcu lated. The ratio of gap to earnings assets is set at the 15% to
20% lev el.
As it is a traditional du ration-based approach, gap reporting is a static
m easu re for risk sensitiv ity at one specifi c point in tim e. It is for this
reason that bank s com bine a v alu e-at-risk m easu re as w ell, or u se it
ex clu siv ely . It is ou tside the scope of this book to consider VaR – w e
cite a u sefu l introdu ctory reference at the end of this chapter (Bu tler,
1998).
Simulation modelling
Sim u lation m odelling is a procedu re that m easu res potential im pact
on the bank ing book – and hence earnings lev els – of a u ser-specifi ed
change in interest rates and/or a change in the shape of the book
itself. This process enables senior m anagem ent to gau ge the risk
associated w ith particu lar strategies. Pu t sim ply the process inv olv es
Constru cting a ‘base’ balance sheet and incom e statem ent as the
starting point (this is deriv ed from the cu rrent shape of the
bank ing book and any changes ex pected from cu rrent grow th
trends that hav e been projected forw ard).
Assessing the im pact on the balance sheet of changes u nder
selected scenarios: say , no change in rates; a 100 bp and 250 bp
u pw ard parallel shift in the y ield cu rv e; a 100 bp and 250 bp
dow nw ard parallel shift; a 25 bp steepening and fl attening of
the y ield cu rv e betw een the 5-m onth and the 3-y ear m atu rity
points; a com bination of parallel shift w ith piv otal shift at a
selected point; an increase or decrease in 3-m onth T-bill y ield
v olatility lev els; and a 20 bp change in sw ap spreads.
Com paring the difference in earnings resu lting from any of the
scenarios to the anticipated earnings stream u nder the cu rrent
env ironm ent.
Generally , the com m ittee sets gu idelines abou t the signifi cance of
sim u lation resu lts; for ex am ple, there m ay be a ru le that for a 100 bp
change in interest rates the im pact on NII shou ld be no m ore than
10% . If resu lts indicate su ch an im pact, the ALCO w ill determ ine
w hether the cu rrent risk strategy is satisfactory or w hether

adju stm ents are necessary .
NPV AND VALUE-AT-RISK

The NPV of a bank ing book is an appropriate target of interest rate
policy becau se it captu res all fu tu re cashfl ow s and is equ al to the
discou nted v alu e of fu tu re m argins w hen the discou nt rate is the cost
of all debt. The sensitiv ity of NPV is deriv ed from the du ration of
assets and liabilities. Therefore, w e m ay w rite the change in NPV as:
NPV 1
D A MV A D L MV L 66
r 1 r
w here D A is the du ration of assets and MV A is the m ark et v alu e of
assets. Equ ation (6.6) is applicable w hen only one interest rate is u sed
for reference. Sensitiv ity w ith respect to interest rate r is k now n. It is
then possible to deriv e v alu e-at-risk (VaR) from these sim ple rela-
tionships. With one interest rate w e are interested in the m ax im u m
v ariation of NPV that resu lts from a change in the reference interest
rate. NPV v olatility can be deriv ed from its sensitiv ity and from
interest rate v olatility . If w e set Sr as the sensitiv ity of NPV to
interest rate r, NPV v olatility is giv en by :
NPV Sr r 67
Once v olatility is k now n, m ax im u m change at a giv en confi dence
lev el is obtained as a m u ltiple of v olatility . The m u ltiple is based on
assu m ptions w ith respect to the shape of the distribu tion of interest
rates. Under a cu rv e w ith norm al distribu tion, a m u ltiple of 1.96
prov ides m ax im u m ex pected change at a 2.5% tw o-tailed confi dence
lev el, so that w e are able to say that the VaR of the book is as giv en by :
VaR 1 96 Sr r 68
Where there is m ore than one interest rate, v ariation in NPV can be
approx im ated as a linear com bination of v ariations du e to the change
in each interest rate. This is w ritten as:
NPV Sr r Ss s St t L 69
w here r, s and t are the different interest rates. Since all interest rate
changes are u ncertain, NPV v olatility is the v olatility of a su m of
random v ariables. Deriv ing the v olatility of this su m requ ires
assu m ptions on correlations betw een interest rates.
This problem is identical to the general problem of m easu ring the

m ark et risk of a portfolio w hen m indfu l that its change in m ark et
v alu e arises as a resu lt of changes generated by random v ariations of
m ark et param eters. The m ain concern is to calcu late the v olatility of
the m ark -to-m ark et v alu e of the portfolio, ex pressed as the su m of
random changes of m ark -to-m ark et v alu es of the v ariou s indiv idu al
transactions . Thes e random changes can be interdependent, in the
sam e w ay that u nderly ing m ark et param eters are. Volatility in the
v alu e of the portfolio depends u pon the sensitiv ities of indiv idu al
transactions , u pon the v olatilities of indiv idu al m ark et param eters
and u pon their interdependency , if any ex ists. The m ethodology that
calcu lates this v olatility is k now n as delta-VaR. This is based on the
delta sensitiv ity of the portfolio to changes in m ark et interest rates.
BIBLIOGRAPHY
Anon. (1998) Asset and Liability Management, RISK Pu blications.
Bitner, J. (1992) Successful Bank Asset–Liability Management, John Wiley
& Sons.
Bu tler, C. (1998) Mastering Value-at-Risk, FT/Prentice Hall.
Chou dhry , M. (2007) Bank Asset and Liability Management, Singapore:
John Wiley & Sons.
Corny n, A. and May s, E. (Eds.) (1997) Interest Rate Risk Models: Theory
and Practice, Glenlak e Pu blishing/Fitzroy Dearborn Pu blishers,
Chapters 6 and 15
Fabozzi, F. and Chou dhry , M. (2004) H andbook of European Structured
Financial Products, John Wiley & Sons.
Fabozzi, F. and Konishi, A. (1996) The H andbook of Asset/Liability
Management, Rev ised Edition, Irw in McGraw -Hill, Chapters 3, 6–8, 12.
Greenbau m , S. and Thak or, A. (1995) C ontemporary Financial Intermedia-
tion, Dry den Press.
Gu p, B. and Brook s, R. (1993) Interest Rate Risk Management, Irw in
Professional Pu blishing.
How e, D. (1992) A G uide to Managing Interest-Rate Risk, New York
Institu te of Finance.
Johnson, H. (1994) Bank Asset/Liability Management, Probu s Pu blishing.
Kam ak u ra Corporation (1998) Asset & Liability Management: A Synthesis
of N ew Methodologies, Risk Pu blications.
Koch, T. (1988) Bank Management, Dry den Press.
Marshall, J. and Bansal, V.K. (1992) Financial Engineering, New York
Institu te of Finance, Chapter 20
Schaffer, S. (1991) ‘Interest rate risk ,’ Business Review, Federal Reserve
Bank of Philadelphia, May /Ju ne, 17–27
Sink ey , J. (1992) C ommercial Bank Financial Management, Fou rth Edition,

Macm illan.
Stev enson, B. and Fadil, M. (1995) ‘Modern portfolio theory : Can it w ork for
com m ercial loans?’ C ommercial Lending Review, 10(2), Spring, 4–12.
Toev s, A. and Haney , W. (1984) Measuring and Managing Interest Rate
Risk, Morgan Stanley .
Toev s, A. and Haney , W. (1986) ‘Measu ring and m anaging interest rate risk :
A gu ide to asset/liability m odels u sed in bank s and thrifts,’ in R. Platt
(Ed.), C ontrolling Interest Rate Risk: N ew Techniques and Applications
for Money Management, John Wiley & Sons.
Wilson, J.S.G. (Ed.) (1988) Managing Banks’ Assets and Liabilities,
Eu rom oney Pu blications.
By Moorad Choudhry
Chapter
7
ASSET AND
LIABILITY
MANAGEMENT III:
THE ALCO
T he third and fi nal strand of ou r look at bank ALM considers the

reporting process, often ov erseen by the asset–liability m anage-
m ent com m ittee (ALCO). The ALCO has a specifi c rem it to ov ersee
all aspects of asset–liability m anagem ent, from the front-offi ce
m oney m ark et fu nction to back -offi ce operations and m iddle-
offi ce reporting and risk m anagem ent. In this chapter w e consider
the salient featu res of ALCO procedu res.
ALCO policy
The ALM reporting process is often ov erseen by the bank ’s ALCO.
It is responsible for setting and im plem enting ALM policy . Its com -
position v aries in different bank s bu t u su ally inclu des heads of
bu s iness lines as w ell as director-lev el staff su ch as the fi nance
director. It also sets hedging policy .
Ty pical m em bership of the ALCO is as follow s:
Members CFO (Chairm an); Depu ty (Head of Financial Accou nting)
CEO (Depu ty Chairm an)
Head of Treasu ry ; Depu ty (Head of Money Mark ets)
MD Com m ercial Bank ing
MD Retail Bank ing
Chief Risk Offi cer
G uests Head of Mark et & Liqu idity Risk
Head of Produ ct Control
Head of ALM/Money Mark ets
Head of Financial Institu tions
Secretary PA to the Head of Treasu ry
The ALM process m ay be u ndertak en by the Treasu ry desk , the ALM
desk or other dedicated fu nction w ithin the bank . In traditional
com m ercial bank s it w ill be responsible for m anagem ent reporting
to the ALCO. The ALCO w ill consider the report in detail at regu lar
m eetings, u su ally m onthly . The m ain points of interest in the ALCO
report inclu de v ariations in interest incom e, the areas that are ex -
periencing fl u ctu ations in incom e and the latest short-term incom e
projections. The ALM report w ill link these three strands across the
grou p as a w hole and to each indiv idu al bu s iness line as w ell. That is,
it w ill consider m acro-lev el factors driv ing v ariations in interest
incom e as w ell as specifi c desk -lev el factors. The form er inclu de
changes in the shape and lev el of the y ield cu rv e, w hile the latter
ASSET AND LIABILITY MANAGEMENT III: THE ALCO 225
Table 7.1 ALCO m ain m ission – bank ALM strategic ov erv iew
Mission Com ponents
ALC O management and reporting Form u lating ALM strategy

Managem ent reporting
ALCO agenda and m inu tes
Assessing liqu idity , gap and interest
rate risk reports
Scenario planning and analy sis
Interest incom e projection
Asset management Managing bank liqu idity book
(CDs, bills)
Managing FRN book
Inv esting bank capital
ALM strategy Yield cu rv e analy sis
Money m ark et trading
Funding and liquidity management Liqu idity policy
Managing fu nding and liqu idity risk
Ensu ring fu nding div ersifi cation
Managing lending of fu nds
Risk management Form u lating hedging policy
Interest rate risk ex posu re
m anagem ent
Im plem enting hedging policy u sing
cash and deriv ativ e instru m ents
Internal Treasury function Form u lating transfer-pricing sy stem
and lev el
Fu nding grou p entities
Calcu lating the cost of capital
inclu de new bu sines s, cu stom er behav iou r and so on. Of necessity

the ALM report is a detailed, large docu m ent.
Table 7.1 is a su m m ary ov erv iew of the responsibilities of ALCO.
The ALCO w ill m eet on a regu lar basis; the frequ ency depends on
the ty pe of institu tion bu t is u su ally once a m onth. The com position
of the ALCO v aries by institu tion bu t m ay com prise the heads of
Treasu ry , trading and risk m anagem ent, as w ell as the fi nance
director. Representativ es from the credit com m ittee and loan sy ndi-
cation m ay also be present. A ty pical agenda w ou ld consider all the
elem ents listed in Table 7.1. Thu s, the m eeting w ill discu s s and
generate action points on the follow ing:
Managem ent reporting – this w ill entail analy sing v ariou s
m anagem ent reports and either signing them off or agreeing
item s to be actioned. The issu es to consider inclu de lending
m argin, interest incom e, v ariance from last projection, cu stom er
bu sines s and fu tu re bu sines s. Cu rrent bu sines s policy w ith
regard to lending and portfolio m anagem ent w ill be rev iew ed
and either continu ed or adju sted.
Bu sines s planning – ex isting asset (and liability ) book s w ill be
rev iew ed, and fu tu re bu sines s directions draw n u p. This w ill
consider the perform ance of ex isting bu sines s, m ost im portantly
w ith regard to retu rn on capital. The ex isting asset portfolio w ill
be analy sed from a risk –rew ard perspectiv e, and a decision tak en
to continu e or m odify all lines of bu sines s. Any proposed new
bu sines s w ill be discu s sed and – if accepted – in principle w ill be
m ov ed on to the nex t stage. 1 At this stage any new bu s iness w ill
be asses sed for projected retu rns, rev enu e and risk ex posu re.
Hedging policy – ov erall hedging policy w ill consider acceptable
lev els of risk ex posu re, ex isting risk lim its and u se of hedging
instru m ents. Hedging instru m ents also inclu de deriv ativ e
instru m ents. Many bank ALM desk s fi nd that their hedging
requ irem ents can be m et u sing plain v anilla produ cts su ch as
interest rate sw aps and ex change-traded short-m oney fu tu res
contracts. The u se of options and especially v anilla instru m ents
su ch as FRAs 2 is m u ch low er than one m ight think . Hedging
policy tak es into accou nt the cash book rev enu e lev el, cu rrent
m ark et v olatility lev els and the ov erall cost of hedging. On
occasion, certain ex posu res m ay be left u nhedged becau se the
costs associated w ith hedging them are deem ed prohibitiv e (this
inclu des the actu al cost of pu tting on the hedge as w ell as the
opportu nity cost associated w ith ex pected redu ced incom e from
the cash book ). Of cou rse, hedging policy is form u lated in co-
ordination w ith ov erall fu nding and liqu idity policy . Its fi nal
form m u st consider the bank ’s v iew s of the follow ing:
New bu siness w ill follow a long process of approv al, ty pically inv olv ing
all the relev ant front-offi ce, m iddle-offi ce and back -offi ce departm ents of
the bank and cu lm inating in a ‘new produ cts com m ittee’ m eeting at w hich
the proposed new line of bu siness w ill be either approv ed, sent back to the
sponsoring departm ent for m odifi cation or rejected.
See Chapter 4.
ex pectations on the fu tu re lev el and direction of interest

rates;
balancing the need to m anage and control risk ex posu re w ith
the need to m ax im ize rev enu e and incom e;
lev el of risk av ersion, and the lev el of risk ex posu re the bank
is w illing to accept.
The ALCO is dependent on m anagem ent reporting from the ALM or
Treasu ry desk – reports m ay be com piled by the Treasu ry m iddle
offi ce. The m ain report is the ov erall ALM report, show ing the
com position of the bank ’s ALM book . Other reports w ill look at
specifi c bu sines s lines and consider the retu rn on capital generated
by these bu sines ses. Thes e reports w ill need to break dow n aggregate
lev els of rev enu e and risk by bu s iness line. Reports w ill also drill
dow n by produ ct ty pe across bu s iness lines . Other reports w ill con-
sider the gap, gap risk , the VaR or DV01 report and credit risk
ex posu res. Ov erall, the reporting sy stem m u st be able to isolate
rev enu es, retu rn and risk by cou ntry sector, bu sines s line and
produ ct ty pe. There is u su ally an elem ent of scenario planning as
w ell, w hich is ex pected perform ance u nder v ariou s specifi ed
m acro-lev el and m icro-lev el m ark et conditions.
Figu re 7.1 illu strates the general reporting concept.
ALCO reporting
We now prov ide a fl av ou r of the reporting that is prov ided to and
analy sed by the ALCO. This is of cou rse a generalization – reports
w ill v ary by ty pe of institu tion and the natu re of its bu sines s.
In Chapter 5 w e show ed an ex am ple of a m acro-lev el ALM report.
The ALCO w ill also consider m acro-lev el gap and liqu idity reports
com piled for produ ct and m ark et. The interest rate gap – sim ply the
difference betw een assets and liabilities – is easily set into these
param eters. For m anagem ent reporting pu rposes the report w ill
attem pt to show a dy nam ic profi le, bu t its chief lim itation is that
it is alw ay s a snapshot of a fi x ed point in tim e, and therefore – strictly
speak ing – w ill alw ay s be ou t of date.
Figu re 7.2 show s a ty pical dy nam ic gap, positioned in a desired ALM

‘sm ile’, w ith projected interest rate gaps based on the cu rrent snap-
shot profi le. This report show s fu tu re fu nding requ irem ents, on
Figure 7.1 ALCO reporting inpu t and ou tpu t.
Figure 7.2 ALM, ex pected liqu idity and interest rate gap –
snapshot profi le.
Figure 7.3 ALM break dow n by produ ct (or m ark et) segm ent.
w hich the ALCO can giv e gu idance refl ecting its v iew on fu tu re
interest rate lev els. It also show s w here sensitiv ity to falling interest
rates, in term s of rev enu e, lies becau se it show s the v olu m e of assets.
Again, the ALCO can giv e instru ctions on hedging if it ex pects
interest incom e to be affected adv ersely . The x-ax is indicates tim e
bu ck ets from ov ernight ou t to 2 y ears or m ore. Bank s u se different
tim e bu ck ets to su it their ow n requ irem ents. 3
Figu re 7.3 show s the sam e report brok en dow n by produ ct (or
m ark et – the report w ou ld hav e a sim ilar lay ou t). We u se a hy po-
thetical sam ple of different bu sines s lines . Using this form at the
ALCO can observ e w hich assets and liabilities are produ cing the
gaps; this is im portant becau se it show s if produ cts (or m ark ets) are
fi tting into ov erall bank policy . Equ ally , policy can be adju sted if
requ ired in response to w hat the report show s. So, the ALCO can see
w hat proportion of total assets is represented by each bu s iness line,
and w hich line has the greatest forw ard fu nding requ irem ent. The
For ex am ple, a bank m ay hav e ju st the ‘ov ernight’ tim e bu ck et or m ay

incorporate it into an ‘ov ernight to 1-w eek ’ period. Sim ilarly , bank s m ay
hav e each period from 1 m onth to 12 m onths in their ow n separate bu ck ets
or m ay place som e periods into com bined tim e periods. There is no single
‘correct’ w ay .
Figure 7.4 ALM break dow n by ty pe of interest rate.
sam e report is show n again in Figu re 7.4, bu t this tim e the

break dow n is by ty pe of interest rate: fi x ed or v ariable.
Another v ariation of this report u nder the scru tiny of the ALCO is a
break dow n by incom e and m argin, again separated into bu sines s
lines or m ark ets as requ ired. In a pu rely com m ercial bank ing opera-
tion the rev enu e ty pe m ix w ill com prise the follow ing (am ong
others):
the bid–offer spread betw een borrow ing and lending in the inter-
bank m ark et;
corporate lending m argin – that is, the loan rate ov er and abov e
the bank ’s cost of fu nds;
trading incom e;
fi x ed fees charged for serv ices rendered.
The ALCO w ill receiv e an incom e break dow n report, split by
bu s iness line. The x-ax is in su ch a report w ou ld show the m argin
lev el for each tim e period; that is, the m argin of the lending rate ov er
the cost of fu nds by each tim e bu ck et. Figu re 7.5 is another ty pe of
incom e report, w hich show s v olu m es and incom e spread by bu s iness
line. The spread is show n in basis points and is an av erage for that
tim e bu ck et (across all loans and deposits for that bu ck et). Volu m es
w ill be those reported in the m ain ALM report (Figu re 7.2) bu t this
tim e w ith m argin contribu tion per tim e period. As w e m ight ex pect,
the spread lev els per produ ct across tim e are rou ghly sim ilar. They
w ill differ m ore m ark edly by produ ct tim e. The latter report is show n
Figure 7.5 Ass et profi le v olu m e and av erage incom e spread.
at Figu re 7.6 (see nex t page), w hich is m ore u sefu l becau se it show s
the perform ance of each bu s iness line. In general, the ALCO w ill
prefer low v olu m es and high m argin as a com bination, becau se low er
v olu m es consu m e less capital. How ev er, som e signifi cant high-
v olu m e bu s iness (su ch as interbank m oney m ark et operations) oper-
ates at a relativ ely low m argin.
The incom e and retu rn reports v iew ed by ALCO are necessary for it
to check w hether bank policy w ith regard to lending and m oney
m ark et trading is being adhered to. Essentially , these reports
prov ide inform ation on the risk –retu rn profi le of the bank . The
ideal com bination is the low est possible risk for the highest possible
retu rn, althou gh of cou rse low -risk bu sines s carries the low est
retu rn. The lev el of tradeoff at w hich the bank is com fortable is
w hat the ALCO w ill set as its direction and strategy . With regard
to v olu m es and bank bu sines s, it m ight be thou ght that the optim u m
m ix is high v olu m e m ix ed w ith high incom e m argin. How ev er, high-
v olu m e bu sines s consu m es the m ost capital, so there w ill be another
tradeoff w ith regard to the u s e of capital.
232
Figure 7.6 Bu siness lines and av erage incom e spread.

AN INTRODUCTION TO BANKING
By Moorad Choudhry
Chapter
8
BANK LIQUIDITY
RISK MANAGEMENT
T he Western World’ s bank ing sy stem w as – in som e ju risdictions

at least – on the brink of collapse in Septem ber and October
2008, in the w ak e of the Lehm an bank ru ptcy . Interv ention by
gov ernm ents, w hich in som e cases ex tended to a blank et gu arantee
of bank s’ com plete liabilities, prev ented this collapse from tak ing
place. In the afterm ath of the crisis, national regu lators and the Bank
for International Settlem ents (BIS) circu lated consu ltativ e papers
and recom m endations that addressed new requ irem ents on bank
capital, liqu idity and risk m anagem ent. The UK’s Financial Serv ices
Au thority (FSA) w as perhaps the m ost dem anding; in its Policy
Statement 09/16, w hich w as issu ed in October 2009, it ou tlined
m easu res on capital treatm ent, liqu idity requ irem ents and stres s-
testing that im plied a fu ndam ental change in the bank ’s bu sines s
m odel going forw ard.
In this and the nex t chapter, w e discu s s the im plications for bank s of
the new em phasis on risk m anagem ent by the regu lators and the BIS
com m ittee – this w as the com m ittee that issu ed the ‘Basel III’ ru les
in Septem ber 2010 for im plem entation from 2015 onw ards. We also
prov ide ou r ow n recom m endations on how bank s can go abou t
m eeting these requ irem ents in a w ay that generates su stained
retu rn on capital. This chapter look s at the fu ndam entals of liqu idity
risk m anagem ent, and w hat its basic principles need to be in the light
of cu rrent central bank and regu latory requ irem ents. In the follow ing
chapter, w e consider the im plications of these changes for the basic
bank ing m odel.
The liquidity policy statem ent

Bu s iness best practice dictates that a bank form ally docu m ents its
liqu idity policy . This w ill articu late the bank ’s approach to and
appetite for liqu idity risk , the actions it shou ld follow to m aintain
liqu idity safety and the contingent actions to follow in the ev ent of
stres sed conditions in the fi nancial m ark ets. We prov ide a tem plate
for bank liqu idity policy here w ith a series of illu strations. They are
self-ex planatory and applicable to a conv entional m ediu m -sized
com m ercial bank .
The basic principles of the policy statem ent are show n in Figu res 8.1
to 8.6. Figu re 8.4 show s the alternativ e actions that can be tak en in
the ev ent of liqu idity stres s. Figu re 8.6 is the su m m ary liqu idity -risk -
reporting tem plate.
BANK LIQUIDITY RISK MANAGEMENT
235
Figure 8.1 Liqu idity policy statem ent: basic fram ew ork .
236
Figure 8.2 Liqu idity policy statem ent: appetite for liqu idity risk .
237
Figure 8.3 Liqu idity policy statem ent: basic fram ew ork .
238
Figure 8.4 Liqu idity policy statem ent: fu nding options.

239
Figure 8.5 Liqu idity policy statem ent: m anagem ent process.
240
Figure 8.6 Liqu idity policy statem ent: su m m ary M1.

BANK LIQUIDITY RISK MANAGEMENT 241
Principles of bank liquidity risk m anagem ent

At a conference hos ted by the UK Financial Serv ices Au thority (FSA)
on 9 October 2009, there w as signifi cant focu s giv en to the m odel of
liqu idity m anagem ent of the HSBC (a UK bank ). Giv en its rarity
am ongst large Western bank s in not su ffering a liqu idity crisis in
2007–2008, observ ers com m ented on the effi cacy of the HSBC
m odel, and on w hat lessons cou ld be learned by bank s in general.
In tru th, a close look at the HSBC’s approach to liqu idity and asset
generation show s that it is neither u niqu e nor proprietary to the
bank ; indeed, a nu m ber of other bank s su ch as Standard Chartered
Bank follow a sim ilar approach. The ‘HSBC m odel’ w ou ld hav e been
the norm , rather than the ex ception, am ongst bank s as recently as 10
or 15 y ears ago. In an era of ex cess the basic tenets of the approach
w ere applied by few er and few er bank s, to the ex tent that they w ere
no longer seen as an essential ingredient of pru dent bank risk
m anagem ent at the tim e of the 2007–2008 fi nancial crash.
As su ch these principles represent the basic principles of bank ing –
not a specifi c response to the ev ents of 2007–2008. They shou ld
be tak en to be general principles of bank ing liqu idity m anagem ent,
and ones that m ore bank s w ill re-adopt as they retu rn to a m ore
conserv ativ e bu s iness m odel, either throu gh choice or becau se the
requ irem ents of the national bank ing regu lator insist u pon a m ore
robu st approach to risk m anagem ent.
This section considers the m ost im portant principles of w hat shou ld
be tak en as the cornerstone of bank ing and liqu idity m anagem ent.
(1) Fund illiquid assets with core customer deposits

In hindsight, this look s an em inently sensible gu ideline bu t du ring
the bu ll m ark et bu ildu p of 2001–2007 it w as not applied u niv ers ally .
The best ex am ple of this w as Northern Rock , w hich bu ilt an asset
book that far ex ceeded its retail deposit base in size, bu t this pattern
w as observ ed w ith m any bank s in Western Eu rope. It is not diffi cu lt
to ascertain the logic behind this principle: core cu stom er deposits
are generally m ore stable than w holesale fu nds and are also at low er
risk of w ithdraw al in the ev ent of a dow ntu rn in econom ic con-
ditions (an apparent paradox is that they m ay actu ally increase as
cu stom ers seek to delev erage and also hold off com m itting to cash-
rich ex penditu re). Therefore, fu nding illiqu id assets w ith core
cu stom er deposits is pru dent bank ing practice.
(2) Where core customer deposits are not available, use long-
term wholesale funding sources
This follow s on natu rally from the fi rst principle. Where there is
insu ffi cient core deposits av ailable, and bank s resort to the w hole-
sale-fu nding m ark et, bank s shou ld ensu re that only long-dated
w holesale fu nds are u sed to fu nd illiqu id assets. Generally , ‘long-
dated’ m eans ov er 1 y ear in m atu rity , althou gh of cou rse the appro-
priate tenor to sou rce is a fu nction of the m atu rity of the asset. This
approach redu ces rollov er liqu idity risk in the ev ent of a crisis.
(3) N o overreliance on wholesale funding. Run a sensible term

structure wherever this is used: more funding should be long
term ( 5 years) than short term
This follow s on from the prim ary dictu m of not bu ilding u p the asset
base u sing w holesale fu nds u nless absolu tely necessary . Where
recou rse is m ade to w holesale fu nds, as m u ch of this as possible
shou ld be long term , so as to m inim ize ex posu re to frequ ent short-
term rollov er risk to w holesale fu nds.
(4) Maintain ‘liquidity buffers’ to cater for stresses –

both firm-specific stresses and market-wide stresses
The UK FSA pu blis hed this requ irem ent in its Policy Statement
09/16 in October 2009. How ev er, only 10 or 15 y ears ago it w as
qu ite com m on for bank s to hold som e of their assets in the form
of liqu id risk -free gov ernm ent bonds. Traditionally , a bank ’s capital
w as alw ay s inv ested in su ch secu rities or in shorter dated gov ern-
m ent bills, bu t bey ond this it w as accepted good practice for bank s to
hav e a proportion of their balance sheet assets in sov ereign secu r-
ities. For the FSA to m ak e it a requ irem ent u nder law dem onstrates
the ex tent to w hich this practice has fallen into disu se.
It is ev ident that bank s redu ced their holdings of gov ernm ent bonds
so they cou ld deploy m ore of their fu nds in higher pay ing risk y
assets. Bu t, the logic of holding a liqu idity bu ffer is irrefu table: in
periods of stress or illiqu idity , gov ernm ent bonds are the only assets
that rem ain liqu id. As su ch, they can be sold to release liqu idity if
need be. Ev en hitherto highly liqu id assets su ch as high-rated bank
CDs or short-dated MTNs becam e illiqu id v irtu ally ov ernight in
the im m ediate afterm ath of the Lehm an collapse in 2008. This
dem onstrates that the liqu idity bu ffer shou ld only be com prised of
sov ereign risk -free secu rities.
(5) Establish a liquidity contingency plan

A w ell-m anaged liqu idity operation recognizes that bank fu nding
shou ld be sou rced from m u ltiple origins, and that ‘concentration
risk ’ shou ld be av oided both in any specifi c sector and any single
lender. How ev er, ev en w ithou t ex cess concentration, at any tim e
particu lar sectors or lenders m ay becom e u nav ailable for either
ex ogenou s or endogenou s reasons.
Giv en this risk , bank s needs to hav e contingencies to fall back on
w henev er particu lar sou rces of fu nding dry u p. This m ay inclu de
apply ing for and setting u p facilities at the central bank , or establish-
ing relationships w ith particu lar sectors that, for reasons of cost
or conv enience, the bank does not cu stom arily access. The
contingency plan needs to be tested regu larly and k ept u pdated.
(6) Know what central bank facilities the bank can access and
test that it really can gain access to them
This follow s logically from the requ irem ent to hav e a contingency
fu nding plan in place. Once a bank has established borrow ing facil-
ities at its central bank , it needs to be aw are ex actly how they
fu nction and w hat the requ irem ents to access them are, so that if
necessary it can benefi t from them w ithou t delay .
(7) Be aware of all the bank’s exposures (on the liability side –
not the credit side). For example, sponsoring an asset-backed
commercial paper (ABC P) conduit creates a reputational,
rather than contractual, obligation to provide funding.
Therefore, be wary of reputational obligations, especially if it
means the bank has to lend its name to another entity
This is fairly straightforw ard to u nderstand, bu t in a bu ll m ark et
w hen credit spreads are tight it is frequ ently forgotten. Bank s m ay
desire the fee-based incom e, at fav ou rable capital lev els, that com es
w ith sponsoring a third-party entity or prov iding a line of liqu idity ,
bu t in a stress situ ation that line w ill be draw n on. Is the bank
prepared to tak e on this additional liqu idity risk ex posu re to an
entity that it m ight not norm ally , in a bear m ark et, w ish to lend
fu nds to?
(8) Liquidity risk is not a single metric. It is an array of metrics,

and a bank must calculate them all in order to obtain the
most accurate picture of liquidity. This is especially true for
multinational banks and/or banks with multiple business
lines
Sm aller bank s often rely on ju st one or tw o liqu idity indicators su ch
as loan-to-deposit ratio. Giv en that bank asset–liability m anagem ent
is m ore an art than a science, it is v ital that bank s u se a range of
liqu idity m easu res for risk estim ation and forecasting. We w ill
address the different m etrics requ ired in the nex t section.
(9) The internal transfer-pricing framework must be set up

correctly and adequately
An artifi cial internal lending rate to bu sines s lines can driv e
inappropriate bu sines s decision-m ak ing and w as a factor behind
the grow th in risk y assets du ring the bu ildu p to the US su bprim e
crisis. We address this su bject on pp. 252–259.
The bu sines s of bank ing is – if nothing else – the bu sines s of
m anaging the gap betw een assets and liabilities. In the history of
bank ing, bank s hav e nev er m atched their asset m atu rity w ith their
fu nding liability m atu rity . Bu t, it is the m anagem ent of this gap risk
that shou ld be the prim ary concern of all bank s. The basic principles
w e hav e discu s sed abov e represent bu sines s best practice – ev olv ed
ov er centu ries of m odern bank ing – in m itigating gap risk .
Measuring bank liquidity risk : k ey m etrics

As w e note abov e, giv en that bank asset–liability m anagem ent is as
m u ch an art as a science, it is v ital that bank s u se a range of liqu idity
m easu res for risk estim ation and forecasting. In this section w e list
sev en baseline liqu idity m etrics w hich all bank s – irrespectiv e of
their size or line of bu sines s – shou ld adopt and m onitor as a m atter
of cou rse:
liqu idity ratio
loan-to-deposit ratio
1-w eek and 1-m onth liqu idity ratios
cu m u lativ e liqu idity m odel
liqu idity risk factor
concentration report
inter-entity lending report.
Thes e reports m easu re and illu strate different elem ents of liqu idity
risk . For consolidated or grou p bank ing entities, reports m u st be at
the cou ntry lev el, legal entity lev el and grou p lev el. Tak en together,
on aggregate the reports prov ide detail on
the ex posu re of the bank to fu nding rollov er or ‘gap’ risk ;
the daily fu nding requ irem ent, and w hat it is lik ely to be at a
forw ard date;
the ex tent of ‘self-su ffi ciency ’ of a branch or su bsidiary .
Liqu idity reports also help in prov iding early w arning of any lik ely
fu nding stres s points. Let u s ex am ine them indiv idu ally .
Liquidity ratio
A bank ’s liqu idity ratio is the basic asset–liability gap ratio.
A liqu idity report for a com m ercial bank is show n in Figu re 8.7.
The liqu idity gap v alu e show n in the report is m ade u p of the assets
m inu s the liabilities of each tenor bu ck et. The ‘total av ailable fu nds’
nu m ber is the liqu idity gap, plu s ‘m ark etable secu rities’ su ch as
gov ernm ent bonds, bank bonds , CDs, m inu s any com m itted facil-
ities that are as y et u ndraw n. The liqu idity ratio calcu lation itself is
the ‘total av ailable fu nds’ v alu e, w hich is 781,065 for the 8-day
bu ck et and 61,438 for the 30-day bu ck et, div ided by the ‘total
liabilities’ v alu e w hich is 4,511,294. This giv es ratios of 17.31%
and 13.6% for the tw o bu ck ets, respectiv ely , w hich are abov e
the bank regu lators’ lim its of 0.00% and 5.00% . In the case of
this bank , the liqu idity ratios m u st not fall below these lim its .
Note that it is the ‘liqu idity gap’ elem ent that driv es the 30-day ratio
to a low er lev el than the 8-day ratio. In other w ords, the bigger the gap
the low er the ratio; this is w hy regu lators place lim its on liqu idity
ratios su ch that bank s are requ ired to m aintain asset–liability gaps at
m anageable lev els.
Loan-to-deposit ratio (LTD )

This is a standard and com m only u sed m etric, ty pically reported
m onthly . It m easu res the relationship betw een lending and cu s-
tom er deposits, and is a m easu re of the self-su stainability of the
bank (or the branch or su bsidiary ). A lev el abov e 100% is an early
w arning sign of ex cessiv e asset grow th; of cou rse, a lev el below 70%
im plies ex cessiv e liqu idity and im plies a potentially inadequ ate
retu rn on fu nds.
246
Figure 8.7 Bank liqu idity report show ing 8-day and 1-m onth liqu idity ratios.
Table 8.1 Sam ple liqu idity ratio report
Country 1-w eek 1-w eek liquidity 1-m onth liquidity

gap
USD This w eek Lim it/ This w eek Lim it/

Ex cess Ex cess
(m illion) (% ) (% ) (% ) (% )
F 1,586 22.83 30.00 39.11 50.00

D 188 15.26 0.00 1.62 5.00
H 786 22.57 0.00 19.12 5.00
G 550 53.27 25.00 69.83 25.00
Regional total 62 0.48 10.64
The LTD ratio is a good m easu re of the contribu tion of cu stom er

fu nding to the bank ’s ov erall fu nding; how ev er, it is not predictiv e
and does not accou nt for the tenor, concentration and v olatility of
fu nds. As su ch it is insu ffi cient as a liqu idity risk m easu re on its ow n
and m u st be u sed in conju nction w ith other m easu res.
1-week and 1-month liquidity ratios

Both the 1-w eek and 1-m onth liqu idity ratios are standard liqu idity
ratios that are com m only m easu red against a regu latory lim it.
An ex am ple of a report for a grou p-ty pe entity com prised of fou r
su bsidiaries is show n in Table 8.1.
Liqu idity ratios are an essential m easu re of ‘gap’ risk . They show
net cash fl ow s – inclu ding the cash effect of liqu idating ‘liqu id’
secu rities – as a percentage of liabilities for a specifi c m atu rity
bu ck et. They are an effectiv e m easu re of stru ctu ral liqu idity , w ith
early w arning of lik ely stress points.
A m ore detailed liqu idity ratio report is show n in Figu re 8.8. This
show s the break dow n of cash infl ow s and ou tfl ow s per tim e bu ck et,
as w ell as the liqu idity ratio. The ratio itself is calcu lated by div iding
the selected tim e bu ck et liability by cu m u lativ e liability . So, in this
ex am ple the 30-day ratio of 17.3% is giv en by the fraction 4781 065
511 294
C umulative liquidity model

The cu m u lativ e liqu idity m odel is an ex tension of the liqu idity ratio
report and is a forw ard-look ing m odel of infl ow s, ou tfl ow s and
av ailable liqu idity , accu m u lated for a 12-m onth period. It recognizes
248
Figure 8.8 Liqu idity report and liqu idity ratio calcu lation.
Figure 8.9 Cu m u lativ e liqu idity m odel.
and predicts liqu idity stres s points on a cash basis. A report su ch as

this – ju st lik e liqu idity ratios – w ill be prepared daily at the legal
entity lev el and grou p lev el.
Figu re 8.9 is an ex am ple of a cu m u lativ e ou tfl ow ou tpu t graph rising

from the cu m u lativ e liqu idity m odel. It giv es a snapshot v iew of
forw ard-fu nding stres s points.
Liquidity risk factor (LRF)

This m easu re show s the aggregate size of the liqu idity gap: it
com pares the av erage tenor of assets w ith that of liabilities. It is
also k now n as a ‘m atu rity transform ation report’. The ratio can be
calcu lated u sing y ears or day s, as desired. For ex am ple, Table 8.2 is an
ex am ple of the risk factor for a hy pothetical bank , w here the u nit of
m easu rem ent is day s. In this ex am ple, 262/19 is slightly below 14.
The higher the LRF, the larger the liqu idity gap and the greater the
liqu idity risk It is im portant to observ e the trend ov er tim e and any
Table 8.2 Liqu idity risk factor
Report date Average liability Average asset Maturity Lim it

tenor tenor transform ation
(day s) (day s) effect
30/09/2009 19 262 14 24
change to long-ru n av erages, so as to get early w arning of the bu ildu p

of a potentially u nsu stainable fu nding stru ctu re.
C oncentration report and funding source report

The concentration report and fu nding sou rce report show the ex tent
of reliance on single sou rces of fu nds. An ex cess concentration to any
one lender, sector or cou ntry is an early w arning sign of potential
stres s points in the ev ent of a crash.
An ex am ple of a concentration report is show n in Table 8.3. In this
table, Cu stom er 1 is clearly the focu s of a potential stres s point, and a
bank w ou ld need to bu ild in som e contingency in the ev ent that this
sou rce of fu nds dries u p.
A related report is the fu nding sou rce report, an ex am ple of w hich is
show n in Table 8.4.
This is a su m m ary of the share of fu nding obtained from all the
v ariou s sou rces , and shou ld be u sed to fl ag potential concentration
risk by sector.
Table 8.3 Large depositors as percentage of total fu nding report
Custom er Deposit am ount Percentage of Percentage of group

bank funding ex ternal funding
000s (% ) (% )
Cu stom er 1 836,395 17.1 2.6

Cu stom er 2 595,784 7.9 1.8
Cu stom er 3 425,709 5.8 1.3
Cu stom er 4 241,012 0.6 0.7
Cu stom er 6 214,500 1.2 0.7
Cu stom er 21 190,711 4.5 0.6
Cu stom er 17 123,654 2.9 0.4
Cu stom er 18 97,877 2.3 0.3
Cu stom er 14 89,344 2.1 0.3
Cu stom er 15 88,842 2.1 0.3
Cu stom er 31 83,272 2.0 0.3
Cu stom er 19 74,815 0.5 0.2
Cu stom er 10 64,639 1.5 0.2
Cu stom er 29 59,575 1.4 0.2
Cu stom er 16 58,613 1.4 0.2
Total 6,562,116 53.3 20.1
Table 8.4 Fu nding sou rce report
Source Balance Funding Lim it Lim it

breach
(EUR000,000s) (% ) (Y/N)
Corporate and retail 1,891 46 40% Y

cu stom ers
Institu tional – fi nancial 675 17 25% or 1bn Y
institu tions
Inter-bank 301 7 25% or 1bn Y
Inter-grou p (net balance) 400 10 25% or 1bn Y
Other 20 0 25% or 1bn Y
Total liabilities 4,087
Inter-entity lending report

The inter-entity lending report is relev ant for grou p and consolidated
bank ing entities. As intra-grou p lending is com m on in bank ing
entities, this report is a v alu able tool u sed to determ ine how
reliant a specifi c bank ing su bsidiary is on grou p fu nds. An
ex am ple of su ch a report is show n in Table 8.5.
We hav e described the range of reports that represent essential
m etrics in the m easu rem ent of liqu idity risk . They are the
m inim u m m anagem ent inform ation (MI) that bank s and grou p
treasu ries w ill w ish to prepare, both as bu sines s best practice and
as part of adherence to new regu latory standards.
Table 8.5 Sam ple inter-com pany lending report
Group Treasury
As at (date) Total borrow ing Total lending Net intergroup

lending
London 1,713,280 883,133 830,157

Paris 3,345,986 978,195 2,367,617
Frank fu rt 17,026 195,096 178,089
Du blin 453,490 83,420 370,070
Hong Kong 0 162,000 162,000
New York 690,949 1,516,251 825,302
Summary liquidity report

For ex ecu tiv e su m m ary reporting to senior m anagem ent, a bank m ay
prov ide a one-sided report of the m ain liqu idity m etrics. An ex am ple
of this is show n in Figu re 8.10.
Internal funding rate policy

We defi ne liqu idity risk as the risk of being u nable to (i) raise fu nds to
m eet pay m ent obligations as they fall du e and (ii) fu nd an increase in
assets. Fu nding risk is the risk of being u nable to borrow fu nds in the
m ark et. The UK regu latory au thority , the Financial Serv ices Au th-
ority , has prescribed a m echanism to m itigate liqu idity and fu nding
risk that is notable for its focu s on the ty pe, tenor, sou rce and
av ailability of fu nding, ex ercised u nder norm al and stres sed
m ark et conditions. 1
This em phasis on liqu idity is correct and an ex am ple of a retu rn to
the roots of bank ing, w hen liqu idity m anagem ent w as param ou nt.
While capital ratios are a necessary part of bank risk m anagem ent,
they are not su ffi cient. Northern Rock and Bradford & Bingley w ere
m ore a failu re of liqu idity m anagem ent than capital erosion. Hence,
it is not su rprising that there is now a strong focu s on ex traneou s
considerations to fu nding.
How ev er, the u se of su ch fu nding w ithin bank s, inclu ding the price
at w hich cash is internally lent or transferred to bu sines s lines , has
not been as closely scru tinized by the FSA. This issu e needs to be
addressed by regu lators becau se it is a driv er of bank bu sines s
m odels, w hich w ere show n to be fl aw ed and based on inaccu rate
assu m ptions du ring 2007–2008.
An effective internal funding framework

While the FSA does tou ch on bank internal liqu idity pricing,2 the
cov erage is peripheral. This is u nfortu nate becau se it is a k ey
elem ent driv ing a bank ’s bu s iness m odel. Essentially , the price at
w hich an indiv idu al bank bu sines s line raises fu nding from its
Treasu ry desk is a m ajor param eter in bu sines s decision-m ak ing,
FSA, Policy Statement 09/16, October 2009.

See p. 23, FSA CP 08/22, Strengthening Liquidity Standards, Decem ber
2008.
The cash gap and the liquidity gap turn negative between 2 days and 1 week
Ratios are above the limit
Figure 8.10 Su m m ary liqu idity snapshot.

driv ing sales , asset allocation, and produ ct pricing. It is also a k ey

hu rdle rate behind the produ ct approv al process and an indiv idu al
bu s iness line’s perform ance m easu rem ent. Ju st as capital allocation
decisions affecting front-offi ce bu s iness u nits need to accou nt for the
cost of that capital (in term s of retu rn on regu latory and econom ic
capital), so fu nding decisions ex ercised by corporate treasu rers carry
signifi cant im plications for sales and trading team s at the trade lev el.
In an ideal w orld, the price at w hich cash is internally transferred
w ithin a bank shou ld refl ect the tru e econom ic cost of that cash (at
each m atu rity band) and its im pact on ov erall bank liqu idity . This
w ou ld ensu re that each bu s iness aligns the com m ercial propensity to
m ax im ize profi t w ith the correct m atu rity profi le of associated
fu nding. From a liqu idity point of v iew , any m ism atch betw een
the asset tenor and fu nding tenor, after tak ing into accou nt the
‘repoability ’ of each asset class in qu estion, shou ld be highlighted
and acted u pon as a m atter of priority , w ith the objectiv e to redu ce
recou rse to short-term , passiv e fu nding as m u ch as possible. Equ ally ,
it is im portant that the internal fu nding fram ew ork is transparent to
all trading grou ps.
A m easu re of discipline in bu s iness decision-m ak ing is enforced
v ia the im pos ition of m inim u m retu rn-on-capital (ROC) targets.
Independent of the internal cost of fu nds, a bu s iness line w ou ld
ordinarily seek to ensu re that any transaction it entered into
achiev ed its targeted ROC. How ev er, rely ing solely on this
m easu re is not alw ay s su ffi cient. For this to w ork , each bu sines s
line shou ld be set ROC lev els that are com m ensu rate w ith its (risk -
adju sted) risk –rew ard profi le. How ev er, bank s do not alw ay s set
different target ROCs for each bu sines s line, w hich m eans that
the requ ired discipline break s dow n. Second, a u niform cost of
fu nds, ev en allow ing for different ROCs, w ill m ean that the different
liqu idity stres ses created by different ty pes of asset are not addressed
adequ ately at the aggregate fu nding lev el.
For ex am ple, consider the follow ing asset ty pes:
a 3-m onth inter-bank loan
a 3-y ear fl oating rate corporate loan, fi x ing qu arterly
a 3-y ear fl oating rate corporate loan, fi x ing w eek ly
a 3-y ear fi x ed rate loan
a 10-y ear fl oating rate corporate loan, fi x ing m onthly
a 15-y ear fl oating rate project fi nance loan, fi x ing qu arterly .
Thes e asset ty pes hav e been deliberately chosen to dem onstrate the
different liqu idity pressu res that each places on the Treasu ry fu nding
desk (listed in increasing am ou nt of fu nding rollov er risk ). Ev en
allow ing for different credit risk ex posu res and capital risk
w eights, the im pact on the liability fu nding desk is different for
each asset; hence, the im portance of apply ing a stru ctu rally sou nd
transfer-pricing policy , dependent on the ty pe of bu s iness line being
fu nded.
Cost of funds
As a k ey driv er of the econom ic decision-m ak ing process, the cost at
w hich fu nds are lent from the central Treasu ry to a bank ’s bu sines s
lines needs to be set at a rate that refl ects the tru e liqu idity risk
position of each bu sines s line. If it is u nrealistic, there is a risk that
transactions are entered into that produ ce an u nrealistic profi t. This
profi t w ill refl ect an artifi cial fu nding gain, rather than the tru e
econom ic v alu e-added of the bu sines s.
There is em pirical ev idence of the dam age that can be cau sed
by artifi cially low transfer pricing. In a w ork ing paper from 2008,
Adrian Blu ndell-Wignall and Pau l Atk inson 3 discu ss the losses at
UBS in its stru ctu red credit bu s iness, w hich originated collateralized
debt obligations (CDOs) and inv ested in them . On p. 97 of their paper
they qu ote a UBS shareholder report,
‘ internal bid prices w ere alw ay s higher than the relev ant
London inter-bank bid rate (LIBID) and internal offer prices
w ere alw ay s low er than relev ant London inter-bank offered rate
(LIBOR).’
In other w ords, UBS’ stru ctu red credit bu sines s w as able to fu nd
itself at prices better than in the m ark et (w hich is im plicitly inter-
bank risk ), despite the fact that it w as inv esting in assets of
considerably low er liqu idity (and credit qu ality ) than inter-bank
risk . There w as no adju stm ent for tenor m is m atch – to better
align term fu nding to liqu idity . A m ore realistic fu nding m odel
w as v iew ed as a ‘constraint on the grow th strategy ’.
This lack of fu nding discipline u ndou btedly play ed an im portant role
in the decision-m ak ing process becau se it allow ed the desk to report
infl ated profi ts based on low fu nding costs. As a stand-alone bu s i-
Blu ndell-Wignall, A., and Atk inson, P. (2008) ‘The su b-prim e crisis:
Cau sal distortions and regu latory reform ,’ w ork ing paper, OECD, Ju ly .
ness, a CDO inv estor w ou ld not ex pect to raise fu nds at su b-Libor,

bu t rather at signifi cantly ov er Libor. By receiv ing artifi cially low
pricing, the desk cou ld report su per profi ts and v ery high ROC,
w hich encou raged increasingly risk y inv estm ent decisions.
Another ex am ple inv olv ed bank s that entered into the ‘fu nd
deriv ativ es’ bu sines s. This w as lending to inv estors in hedge
fu nds v ia a lev eraged stru ctu red produ ct. Thes e instru m ents w ere
illiqu id, w ith m atu rities of 2 y ears or longer. Once dealt, they cou ld
not be u nw ou nd, thu s creating signifi cant liqu idity stress for the
lender. How ev er, bank s fu nded these bu sines s lines from the central
Treasu ry at Libor fl at, rolling ov er the short term . The liqu idity
problem s that resu lted becam e apparent du ring the 2007–2008
fi nancial crisis, w hen inter-bank liqu idity dried u p.
Many bank s operate on a sim ilar m odel, w ith a fi x ed internal fu nding
rate of Libor plu s, say , 15 bp for all bu sines s lines and for any tenor.
Bu t, su ch an approach does not tak e into accou nt the differing risk –
rew ard and liqu idity profi les of the bu s inesses. The corporate lending
desk creates different liqu idity risk ex posu res for the bank com pared
w ith the CDO desk or the project fi nance desk . For the m ost effi cient
capital allocation, bank s shou ld adju st the basic internal transfer
price for the resu lting liqu idity risk ex posu re of the bu sines s. Other-
w is e, they ru n the risk of ex cessiv e risk -tak ing heav ily infl u enced by
artifi cial fu nding gains.
Business best practice

It is im portant that the regu latory au thorities rev iew the internal
fu nding stru ctu re in place at the bank s they su perv ise. An artifi cially
low fu nding rate can create as m u ch potentially u nm anageable risk
ex posu re as a risk -seek ing loan origination cu ltu re. A regu latory
requ irem ent to im pos e a realistic internal fu nding arrangem ent
w ill m itigate this risk . We recom m end the follow ing approach:
a fi x ed add-on spread ov er Libor for term loans or assets ov er a
certain m atu rity – say , one y ear, w here cou pon refi x is frequ ent
(su ch as w eek ly or m onthly ) – to com pensate for liqu idity m is-
m atch. The spread w ou ld be on a sliding scale for longer term
assets.
Internal fu nding discipline is as pertinent to bank risk m anagem ent
as capital bu ffers and effectiv e liqu idity m anagem ent discipline. As
bank s adju st to the new liqu idity requ irem ents soon to be im pos ed
by the FSA, it is w orthw hile for them to look bey ond the literal scope
of the new su perv isory fi at and consider the internal determ inants of
an effi cient, cost-effectiv e fu nding regim e. In this w ay they can m ov e
tow ards the heart of this proposition, w hich is to em bed tru e fu nding
cost into bu s iness line decision-m ak ing.
Funds transfer-pricing policy: liquidity

premium framework
This policy fram ew ork has been introdu ced to better refl ect the
u sage and prov ision of fu nds that fl ow throu gh the Treasu ry as a
resu lt of the bu sines s u ndertak en by indiv idu al bank bu sines s lines
(SBUs). It is m eant to be refl ectiv e of m ark et conditions and is
separate from any Treasu ry m argin that m ay be applied.
It is also a requ irem ent of the UK FSA u nder its Policy Statement
09/16 that the cost of liqu idity shou ld be inclu ded as part of the
internal pricing of fu nds w ithin an entity . We refer to this internal
fu nding rate as the ‘transfer price’ (TP).
TP does not in any w ay refl ect credit spread or credit prem iu m . It is
pu rely a liqu idity prem iu m .
Scope
This policy applies to all interest-bearing assets and liabilities on
the bank ’s balance sheet, effectiv e from 1 Janu ary 2010 onw ards .
It inclu des
all interest-bearing assets and liabilities that are ‘liv e’ – that is,
legacy transactions – as at 1 Janu ary 2010;
separate trading desk s w ithin the Treasu ry ;
gross cashfl ow s of each SBU/trading desk – as per ex isting
transfer-pricing ru les for interest rate risk , there is no netting
allow ed by SBUs.
Non-interest-bearing assets and liabilities are cov ered u nder a
separate policy .
Framework
The TP policy applies equ ally to both sides of the balance sheet.
Assets
The fram ew ork for the pricing of assets is as follow s:
Libor w ill be u sed as the basis for fu nding as per ex isting transfer
pricing ru les .
The fi nal m atu rity date for assets is to be determ ined by reference
to econom ic life or legal m atu rity date w hichev er is the shorter;
econom ic life, in the case of corporate lending/secu rities, is to be
determ ined on a case-by -case basis althou gh the legal m atu rity
date is to be u sed as the defau lt endpoint.
The fram ew ork applies to legacy trades.
The pricing fram ew ork has been set by the Treasu ry and agreed
by the bank ’s ALCO as:
Period to 6 mo 6 m o–12 m o 1 y r–5 y r 5 yr

m aturity
Ass ets Libor Libor 15 bp Libor 20 bp Libor 50 bp
Liabilities
The proposed fram ew ork for the pricing of liabilities is as follow s:
Libor w ill be u s ed as the basis for fu nding as per ex isting transfer-

pricing ru les .
The fi nal m atu rity date for liabilities is to be determ ined by
reference to econom ic life or fi nal m atu rity date w hichev er is
the longer; econom ic life w ill be determ ined w ith reference to the
stick iness rate allow ed by the FSA u nder cu rrent reporting ru les :
Corporate deposits 50%
Retail deposits 60%
For the pu rposes of this fram ew ork , deposits that hav e had
stick iness applied w ill be treated as hav ing an econom ic life of
1-to-5 y ears. Stick iness is applied on a portfolio basis.
The fram ew ork applies to legacy trades.
The pricing fram ew ork has been set by the Treasu ry and agreed
by the ALCO as:
Period to 6 mo 6 m o–12 m o 1 y r–5 y r 5 yr

m aturity
Liabilities Libor Libor 15 bp Libor 20 bp Libor 50 bp
Ongoing
On an ongoing basis
the ALCO is responsible for ensu ring that this policy is
m aintained;
a rev iew of the pricing fram ew ork is to be u ndertak en by the
ALCO ev ery 6 m onths;
pricing can be u pdated m ore frequ ently shou ld m ark et conditions
requ ire it.
Calculation methodology: the liquidity premium

The TP rate w ill be rev iew ed ev ery 6 m onths to ensu re that it is
realistic to the m ark et.
There is no u niv ersal m ethod to calcu late the liqu idity prem iu m that
shou ld be added to the Libor fu nding cost.
Methods that hav e been u sed inclu de
the difference betw een the ASW and CDS of the bank s (w here
this is negativ e) for each tenor m atu rity ;
the difference betw een the fu nding spread ov er a bank of the sam e
credit rating;
a su bjectiv e add-on based on w hat the ALCO believ es the bank
w ill pay to raise longer dated fu nds, separate from the credit risk
perception of the bank .
Conclusion
In this chapter w e hav e considered the essential principles of
bank liqu idity risk m anagem ent. The ev ents of 2007–2008 serv e
to re-iterate the im portance of sou nd ALM practice in bank s. For
this reason it is im portant that a bank ’s ALCO be set u p as an
effectiv e m anagem ent entity and be em pow ered to ensu re correct
bu s iness practice for asset–liability m anagem ent. The fram ew ork set
ou t in this chapter can be v iew ed as a best endeav ou rs approach to
operation of the ALCO fu nction at a bank .
By Moorad Choudhry
Chapter
9
A SUSTAINABLE
BANK BUSINESS
MODEL: CAPITAL,
LIQUIDITY AND
LEVERAGE
T he global fi nancial crisis has had the effect of m ak ing all

participants in the bank ing indu stry – from regu lators,
central bank s and gov ernm ents to bank boards, directors and trade
associations – u ndertak e a fu ndam ental rev iew of the principles of
bank ing. Issu es su ch as capital and liqu idity m anagem ent as w ell as
sy stem ic risk becam e the su bject of renew ed focu s. In practical
term s, legislators realized that they needed to address the issu e of
the ‘too-big-to-fail’ bank , and this issu e rem ains u nresolv ed.
From the point of v iew of bank practitioners, the m ost im portant

task is to address the issu es of capital, liqu idity and risk m anagem ent
and w ork them into a coherent strategy that is designed to produ ce
su stainable retu rns ov er the bu sines s cy cle. In this chapter w e
discu s s these topics and consider how bank strategy can be
form u lated to handle the changed requ irem ents of the post-crisis
age. The contents are laid ou t as follow s:
bank bu sines s m odels

strategy
corporate gov ernance
liqu idity risk and the liqu id asset bu ffer.
We conclu de w ith a v iew on su stainable bank ing.
The new bank business m odel

The basic bank bu sines s m odel has rem ained u nchanged ev er since
bank s becam e an integral part of m odern society . Of cou rse, as it
m ore of an art than science, the m odel param eters them s elv es can be
set to su it the specifi c strategy of the indiv idu al bank , depending on
w hether the strategy operates at a higher or low er risk –rew ard
profi le. How ev er, the basic m odel is identical across all bank s.
In essence, bank ing inv olv es tak ing risk s follow ed by effectiv e
m anagem ent of that risk . This risk can be categorized as follow s:
m anaging the bank ’s capital;

m anaging the liqu idity m is m atch – a fu ndam ental ingredient of
bank ing is ‘m atu rity transform ation’ , the recognition that loans
(assets) generally hav e a longer tenor than deposits (liabilities).
If w e w is hed to su m m arize the basic ingredients of the historical

bank m odel, w e m ight describe it in the follow ing term s:
A SUSTAINABLE BANK BUSINESS MODEL 263
Lev erage – a sm all capital base is lev ered u p into an asset pool
that can be 10 to 30 tim es greater (som etim es ev en higher).
The ‘gap’ – essentially , fu nding short to lend long – is a fu nction
of the conv entional positiv e-sloping y ield cu rv e and dictated by
recognition of the asset–liability m is m atch noted abov e.
Liqu idity – an assu m ption that a bank w ill alw ay s be able to roll
ov er fu nding as it falls du e.
Risk m anagem ent – an u nderstanding of credit or defau lt risk .
Thes e fu ndam entals rem ain u nchanged. The critical issu e for bank
m anagem ent, how ev er, is that som e of the assu m ptions behind the
application of these fu ndam entals have changed, as dem onstrated by
the crash of 2007–2008. The changed landscape in the w ak e of the
crisis has resu lted in som e hitherto ‘safe’ or profi table bu s iness lines
being v iew ed as risk y . Althou gh fav ou rable conditions for bank ing
m ay w ell retu rn in du e cou rse, for the foreseeable fu tu re the chal-
lenge for bank s w ill be to set their strategy only after fi rst arriv ing at a
tru e and fu ll u nderstanding of econom ic conditions as they ex ist
today . The fi rst su bject for discu s sion is to consider w hat a realistic,
su stainable retu rn on the capital target lev el shou ld be and to ensu re
that it is com m ensu rate w ith the lev el of risk av ersion desired by the
board. The board shou ld also consider the bank ’s capital av ailability
and w hat am ou nt of bu sines s this cou ld realistically su pport. Thes e
tw o issu es need to be addressed before the rem ainder of the bank ’s
strategy can be considered.
Bank strategy
The m ost im portant fu nction that a bank ’s board can u ndertak e is to
set the bank ’s strategy . This is not as obv iou s as it sou nds. It is v ital
that bank s hav e a coherent, articu lated strategy in place that sets the
tone for the entire bu sines s, from the top dow n.
In the fi rst instance the board m u st tak e into accou nt the cu rrent
regu latory env ironm ent. This inclu des the requ irem ents of the forth-
com ing Basel III ru les . A bank cannot form u late strategy w ithou t a
clear u nderstanding of the env ironm ent in w hich it operates . Once
this is achiev ed – before proceeding w ith a form al strategy – the bank
needs to determ ine w hat m ark ets it w ishes to operate in, w hat
produ cts and w hat class of cu stom er. All its indiv idu al bu sines s
lines shou ld be set u p to operate w ithin the m ain strategy , once
m ark ets and cu stom ers hav e been identifi ed.
In other w ords, a bank cannot afford to operate by sim ply m eandering

along, noting its peer grou p m ark et share and RoE and m ak ing u p
strategy as it goes along. This approach, w hich again is ev idently
w hat m any bank s do indeed follow – how ev er inadv ertently – resu lts
in a senior m anagem ent and board that is not fu lly aw are of w hat the
bank ’s liabilities and risk ex posu res are.
The fi rst task is to u nderstand one’s operating env ironm ent. Then, it
is to incorporate a specifi c target m ark et and produ ct su ite as the
basis of its strategy . Concu rrent w ith this, the bank m u st set its RoE
target, w hich driv es m u ch of the bank ’s cu ltu re and ethos. It is
im portant to get this part of the process right at the start. Prior to
the crash, it w as com m on for bank s to seek to increase rev enu e by
adding to their risk ex posu re. Ass ets w ere added to the balance sheet,
or higher risk assets w ere tak en on. In the bu ll m ark et env ironm ent
of 2001–2007 – allied to low fu nding costs as a resu lt of low base
interest rates – this resu lted in ev er higher RoE fi gu res, to the point
w here it w as com m on for ev en Tier 2 bank s to target lev els of 22% to
25% RoE in their bu s iness appraisal. This process w as of cou rse not
tenable in the long ru n.
The second task – follow ing on im m ediately from the fi rst – is to set a
realistic RoE target and one that is su stainable ov er the entire bu si-
ness cy cle. This cannot be done w ithou t edu cating board directors as
w ell as shareholders, w ho m u st appreciate the new , low er RoE
targets. Managing ex pectations w ill contribu te to a m ore dis-
passionate rev iew of strategy . Ju st as im portantly , risk -adju sted
RoE shou ld also be set at a realistic lev el and not be allow ed to
increase. Hence, the board and shareholders m u st accept that
low er RoE lev els w ill becom e the standard. This shou ld also be
allied to low er lev erage lev els and higher capital ratios.
Concu rrently w ith the abov e process, a bank m u st also ask itself
w here its strengths lie and form u late its strategy arou nd that. In
other w ords, it is im portant to focu s on core com petencies. Again,
the ex perience of the crash has serv ed to dem onstrate that m any
bank s fou nd them s elv es w ith risk ex posu res that they did not u nder-
stand. This m ay hav e been sim ply the holding of assets (su ch as
stru ctu red fi nance secu rities) w hose credit ex posu res, v alu ation and
secondary m ark et liqu idity they did not u nderstand, or em bark ing on
inv estm ent strategies su ch as negativ e basis trading w ithou t being
aw are of all the m easu rem ent param eters of su ch strategies. 1 To

im plem ent a coherent, articu late strategy properly , a bank needs
to be aw are of ex actly w hat it does hav e (or does not hav e) ex pertise
for u ndertak ing, and not operate in produ cts or m ark ets in w hich it
has no genu ine k now ledge base.
Allied to an u nderstanding of core com petence is a rev iew of core and
non-core assets. Bank strategy is not a static process or docu m ent,
bu t rather a dy nam ic one. Regu lar rev iew s of the balance sheet need
to be u ndertak en to identify any non-core assets, w hich can then be
asses sed to determ ine w hether they rem ain com patible w ith the
strategy . If they are not, then a realistic disposal process w ou ld
need to be draw n u p. In the long ru n, this is connected w ith an
u nderstanding of w here the bank ’s real strengths lie. Long-term
core assets m ay w ell differ from core assets, bu t this needs to be
articu lated ex plicitly . The decision on w hether an asset is core or
non-core, or short-term core or long-term core, is a fu nction of the
bank ’s ov erall strategy – based on its ex pertise – and w hat m ark ets
and cu stom ers it w ishes to serv ice. This w ill be em bedded in the
strategy and the bank ’s bu sines s m odel. This driv es the choice of
produ cts and bu sines s lines to w hich the bank feels it can add v alu e.
Leverage ratios
We discu s s bank s’ capital stru ctu res on p. 268. There is no dou bt that
the new m odel for bank ing assu m es higher capital ratios and bu ffers
for all bank s du ring the nex t 10 y ears. The higher lev el of capital w ill
be su bstantial in som e cases becau se u nder the proposed ‘Basel III’
ru les trading bu sines s w ill be requ ired to hold u p to three tim es as
m u ch capital as v anilla bank ing bu sines s. It is also ev ident that
Withou t nam ing the bank s, the au thor is aw are of institu tions that
pu rchased ABS and CDO secu rities u nder the belief that the senior tranche,
rated AAA, w ou ld not be dow ngraded ev en if there w as a defau lt in the
u nderly ing asset pool, presu m ably becau se the ju nior note(s) w ou ld absorb
the losses. Of cou rse, this loss of su bordination does erode the initial rating
of the senior note – w ith a consequ ent m ark dow n in m ark et v alu e. Another
institu tion, according to anecdotal ev idence receiv ed by em ail, entered into
negativ e basis trades w ithou t any consideration for the fu nding cost of the
trade pack age. This resu lted in losses irrespectiv e of how the basis
perform ed. In this case, it is clear that the trading desk in qu estion entered
into a relativ ely sophisticated trading strategy w ithou t being su ffi ciently
aw are of the technical im plications.
m any bank ju risdictions w ill, in addition, im plem ent lev erage ratio
lim its.
A lev erage ratio is the total v alu e of a bank ’s assets relativ e to its
equ ity capital. The fi nancial crash highlighted the ex tent of risk -
tak ing by certain bank s w hen m easu red u sing lev erage ratios. As a
m easu re of the ratio of assets to ow ners ’ equ ity , they are an ex plicit
indication of risk ex posu re. Lehm an Brothers ’ lev erage ratio in-
creased from approx im ately 24 in 2003 to ov er 31 by 2007.
Su ch aggressiv e asset grow th generated trem endou s profi ts du ring
the boom y ears, bu t ex posed the bank to su ch an ex tent that ev en a
3% or 4% decline in the v alu e of its assets w as capable of com pletely
elim inating its equ ity . As w e are all aw are, this du ly happened.
The Basel Com m ittee on Bank ing Su perv ision (BCBS) and som e
national regu latory au thorities are going to introdu ce a lim it on
lev erage ratios as an added safety m easu re alongside capital requ ire-
m ents. In the afterm ath of the crash it is accepted that bank lev erage
ratios hav e to adju st dow nw ards, and the prev ailing sentim ent today
dictates that boards shou ld be w ary of a bu sines s m odel that ram ps
u p the ratio to an ex cessiv e lev el. Figu re 9.1 show s lev els du ring
2007–2009; pru dent m anagem ent su ggests av erage lev els w ill be
m u ch low er than these fi gu res du ring the nex t 10–15 y ears. This
is bu s iness best practice, becau se low er av erage lev erage ratio lev els
also contribu te to greater sy stem ic stability .
Bank m anagem ent w ill hav e to adju st to the concept of an ex plicit
ratio lim it, the rationale for w hich is clear. The ex perience of the last
and prev iou s crises has show n that du ring a period of u pside grow th
Figure 9.1 Bank m edian lev erage ratios, 2007–2009.

Source: Bank of England (2009).
Figure 9.2 Selected bank ratio of total assets to Tier 1 capital and
trading assets to total assets.
bank s’ risk m odels tend to u nderestim ate their ex posu re; this has
tw o consequ ences: fi rst, the bank tak es on ev er-greater risk as it
targets greater rev enu e and profi t du ring a bu ll m ark et and, second,
the am ou nt of capital set aside is below w hat is adequ ate at the tim e
the crash occu rs. Figu re 9.2, w hich show s a sam ple of ‘bu lge-brack et’
bank s, su ggests that bank s focu sed on trading assets as they
ex panded their balance sheets .
In su ch an env ironm ent, capital ratio requ irem ents are insu ffi cient
to safegu ard against instability , and it becom es necessary to m onitor
lev erage ratios. Hence, in the post-crash env ironm ent bank s need to
adju st their bu sines s strategy to allow for this constraint.
As w e noted abov e in the case of Lehm an’s, ex cessiv ely high lev erage
resu lts in a higher sensitiv ity of the balance sheet to trading and/or
defau lt losses. Lim iting the am ou nt of lev erage acts as an additional
risk control m easu re, back ing u p the safety net prov ided by a
regu latory capital bu ffer. In adv ance of the introdu ction of a
standardized ratio – as part of a fu tu re Basel III – bank s can
address this issu e them s elv es as part of their pru dential capital
and risk m anagem ent.
Note that a nu m ber of ju risdictions already em ploy a lev erage ratio

lim it, althou gh there is no u niform defi nition (see Table 9.1). It is
lik ely that the new Basel III ru les w ill incorporate a lim it, along w ith
a com m on defi nition of capital and an agreed m easu re of all assets,
both on balance sheet and off balance sheet.
Table 9.1 Su m m ary of selected regu latory lev erage ratio lim its
C anada Tier 1 and Tier 2 capital m u st be at least 5% of on-

balance-sheet assets plu s qu alify ing off-balance-sheet
assets
Switzerland Tier 1 capital m u st be at least 3% of on-balance-sheet
assets less Sw iss dom estic lending for bank holding
com panies, and at least 4% for indiv idu al institu tions
U nited States Tier 1 capital m u st be at least 3% of on-balance-sheet
assets for ‘strong’ bank holding com panies and at
least 4% for all other bank holding com panies
Capital structure
The effi cient m anagem ent of capital is a v ital fu nction of bank senior
m anagem ent. In the afterm ath of any recession, capital is of cou rse a
scarce com m odity . How ev er, this fact itself leads to one of the
less ons learned from the crisis: the need for ‘cou ntercy clical’
capital m anagem ent. In other w ords, boards shou ld treat capital as
scarce at all tim es, and bu ild u p capital bases ev en as a bu ll m ark et is
helping to generate higher profi ts. The lev el of capital needs to be
su ffi cient to cu shion the fallou t from ‘stress ev ents’, w hich are the
ou tlier ev ents that norm al distribu tion m odels of fi nance do not
captu re.
Contingent capital instru m ents can conv ert to equ ity w henev er the
issu ing bank ’s capital ratio falls below a pre-specifi ed lev el. Going
forw ard, this shou ld be the only ‘sophisticated’ fi nancial instru m ent
in the bank ’s capital stru ctu re. It w ill assist effi cient capital m anage-
m ent, as w ell as inv estor transparency , if a bank ’s capital is ju st held
in the form of sim ple instru m ents : essentially , com m on equ ity and
retained profi ts (reserv es ). Of cou rse, long-dated debt instru m ents
can also form part of capital, bu t again it is m ore transparent if these
are v anilla instru m ents .
Capital on its ow n is an insu ffi cient protection against fi rm failu re.

This is w hy bank m anagem ent m u st tak e additional m easu res, ov er
and abov e capital bu ffers, to safegu ard the institu tion in the ev ent of
sy stem ic stres s or other m ark et crash ev ents, becau se the capital
base in isolation w ill be insu ffi cient to preserv e the fi rm as a going
concern. Hence, lev erage ratio lim its and robu st liqu idity m anage-
m ent is as im portant as capital bu ffers. A report from the Bank of
England (2009) has su ggested that, on av erage, a Tier 1 capital ratio of
8.5% w ou ld hav e been needed by bank s to av oid falling below the
Basel m inim u m of 4% du ring the last crisis. This su ggests that the
cu rrent requ irem ent is far too low to act as a genu ine risk -based
capital reserv e. Of cou rse, a fi nancial crisis w ill affect different bank s
in different w ay s; the Bank of England report goes on to state that
ev en if all the bank s in its stu dy sam ple had indeed possess ed a Tier 1
ratio of 8.5% , as m any as 40% of these bank s w ou ld still hav e
breached their 4% lim it du ring the crash. For som e fi rm s the
‘hinds ight’ su ffi cient lev el of capital w as as high as 18% .
The im plications of the Bank of England report are clear: m inim u m

capital requ irem ents m u st be higher and bank s need to bu ild an
elem ent of fl ex ibility into their capital stru ctu re, perhaps by
m eans of the contingent capital instru m ents discu s sed in Chapter
5. Contingent capital is any instru m ent that w ou ld conv ert into
com m on equ ity on occu rrence of a pre-specifi ed trigger. This is
illu strated in Figu re 9.3. An issu e of bonds by Lloy ds Bank ing
Grou p in 2009, called ‘enhanced capital notes’ , w as of this ty pe.
Su ch instru m ents enable a bank to pu rchase catastrophe insu rance
from the priv ate sector rather than the pu blic sector v ia the lender of
last resort. They also allow a bank to hold a Tier 1 equ ity reserv e at a
low er cost than equ ity itself, in theory at least.
Figure 9.3 Illu stration of contingent capital note triggering.

Figure 9.4 Cros s-border bank lending v olu m es, 2000–2009.

Core competence: ‘know your risk’

Regu latory au thorities noticed a considerable decline in cross-border
lending fl ow s in the afterm ath of the Lehm an bank ru ptcy (see Bank
of England, 2009). This is signifi cant. Du ring the bu ll m ark et of
2001–2007, international lending v olu m es had ex panded steadily
(see Figu re 9.4), as bank s grew their balance sheets and sou ght
higher y ield opportu nities elsew here.
It is ev ident that du ring and after the bank crisis, w hen interbank
m ark et liqu idity had dried u p, bank s pu lled back from ov erseas
m ark ets, irrespectiv e of w hether these w ere deem ed peripheral or
not, and concentrated on core m ark ets. This refl ects inform ational
adv antages in core m ark ets com pared w ith ov erseas and non-core
m ark ets. The UK corporate lending sector is a case in point: betw een
2002 and 2009, the lending v olu m e from UK bank s fell by
approx im ately 16% (the fi gu re betw een 2006 and 2009 w as a
decline of 14% ). How ev er, the equ iv alent fi gu res for foreign su b-
sidiaries w as a fall of 10.5% and 20% w hile for foreign branches the
decline w as ev en m ore dram atic, at 17% and 46% . 2 Foreign bank s
w ou ld, on av erage, hav e less depth and breadth in their corporate
relationships, w hile branches w ou ld be ex pected to hav e ev en less
dev eloped relationships in the dom estic m ark et.

The lessons for the bank bu s iness m odel are clear: du ring an
ex pansionary phase, it is im portant to rem ain focu sed on areas of
core com petence and sectors in w hich the bank possess es actu al
k now ledge and strength. Concentrating on areas in w hich the
bank carries com petitiv e adv antage m ak es it less lik ely that loan
origination standards w ill decline, resu lting in low er losses du ring an
econom ic dow ntu rn. There is also a technical reason for ensu ring
that ov erseas lending standards are m aintained strictly and lim its
set carefu lly becau se it is often u ndertak en in foreign cu rrency .
A bank ’s ability to fu nd su ch lending is m ore dependent on ex ternal
m ark ets and w holesale cou nterparties relativ e to dom estic lending,
thu s m ak ing the bank m ore v u lnerable to a m ark et dow ntu rn.
For ex am ple, the cross-cu rrency sw ap m ark et in US dollars cam e
u nder pressu re resu lting in higher sw ap prices, follow ing the
Lehm an defau lt, and m any bank s stru ggled to obtain dollar
fu nding.
Liquidity risk m anagem ent

In the afterm ath of the crisis the UK’s Financial Serv ices Au thority
pu blished C onsultative Paper 08/22 and C onsultative Paper 08/24 in
2008, the recom m ended requ irem ents of w hich w ere form alized in
its Policy Statement 09/16 in October 2009. Thes e docu m ents hav e
set a standard for bank liqu idity m anagem ent that is ex pected to be
m irrored, in part if not w holly , in other ju risdictions arou nd the
w orld. As su ch they hint at a new facet of the basic bank bu s iness
m odel that concentrates on the liabilities’ side of the balance sheet.
In essence the FSA has recognized that the crisis of 2007/2008 w as as
m u ch a liqu idity crisis as a capital loss crisis and has acted to
m itigate this risk going forw ard.
Liquidity management: the new model

The basic tenets of the FSA’s proposals are grou nded in m ark et logic.
Their content is ex pected to becom e bu sines s best practice in du e
cou rse, and bank boards and senior m anagem ent need to incorporate
these tenets in their operating m odels . The salient points inclu de
the nu m ber of m is m atch (gap) lim its are increased, as is
su perv isory ov ersight;
increased international co-operation betw een regu lators;
bank -liqu idity -reporting obligations and their frequ ency are
increased;
certain behav iou ral adju stm ents that w ere prev iou sly allow ed are
now rev ok ed or redu ced; for ex am ple, intra-grou p com m itted
liqu idity facilities no longer cou nt as au tom atic fu nding self-
su ffi ciency ;
other behav iou ral adju stm ents are to be rev iew ed on a case-by -
case basis – for ex am ple, the treatm ent of deposit ‘stick iness’;
new requ irem ents to hold bu ffers of tru ly liqu id assets – this is
discu ssed on p. 276;
new requ irem ents to increase the av erage tenor of fu nding and
div ersify the sou rces of fu nds.
The m ain im plication of these requ irem ents is increased cost and,
all else being equ al, low er RoE. Other im plications for this new
bu s iness m odel inclu de
greater lev el of gov ernance responsibility by senior m anagem ent

and the board;
im prov ed liqu idity risk m anagem ent capability (inclu ding better
u se of stress-testing and im prov ed contingency -fu nding plans);
decreased reliance on short-term w holesale fu nding;
greater incentiv e for a bank to attract retail tim e deposits and
longer term w holesale deposits;
higher am ou nt and qu ality of liqu id asset stock s (inclu ding a
higher proportion held in gov ernm ent bonds) – the liqu id asset
bu ffer;
in theory , slow er ex pansion of bank lending du ring fav ou rable
econom ic tim es.
The m ain im plication for bank s is increased lik elihood of their

su rv iv ing a liqu idity stress ev ent.
Another aspect of the new bank m odel requ ired by regu lators is m ore
in-depth and realistic stres s-testing. Ju risdictions w ill differ in detail.
Tak ing the FSA papers as an ex am ple, how ev er, bank s shou ld
im plem ent the follow ing stress tests:
(1) Under the banner of nam e-specifi c shock s

– Is there a risk of an u nforeseen nam e-specifi c shock ?
– Is there a chance the m ark et perceiv es the fi rm to be
potentially insolv ent in the short term ?
– What w ou ld be the long-term im pact of a m u lti-notch
dow ngrade in credit rating?
(2) Under the banner of m ark et-w ide dislocation

– Is there a risk of u nfores een short-term m ark et-w ide
dislocation that gradu ally ev olv es into long-term m ark et-
w ide liqu idity stress?
– Are there w idespread concerns abou t the solv ency of the
fi nancial sector?
– Is there u ncertainty abou t the v alu e of fi nancial assets?
– Is there a risk of certain asset class es rem aining illiqu id for a
long period?
(3) A com bination of (1) and (2).
Using the FSA tem plate as a gu ide, a bank shou ld stres s-test the
follow ing m ain risk driv ers:
w holesale fu nding risk
intra-grou p fu nding risk
intra-day liqu idity risk
cross-cu rrency liqu idity risk
retail fu nding risk
size and qu ality of liqu idity bu ffer
w holesale (u nsecu red) lending and retail loans
off-balance-sheet liqu idity risk
continu ation of bu sines s
div ersifi c ation of fu nding sou rces.
Responsibility for form u lating the stress tests, ensu ring that they are
carried ou t robu stly and at the requ ired frequ ency , and reporting the
resu lts to the board, lies w ith the chief risk offi cer. Under bu s iness
best practice cu ltu re, this person w ill report direct to a NED on the
board.
Basel Committee proposals and the net stable funding ratio

The Basel Com m ittee for Bank ing Su perv ision (BCBS) pu blished
ex tensiv e proposals for a rev am p of certain aspects of the Basel
ru les – term ed ‘Basel III’ – for im plem entation from the end of
2012. In this section w e consider the im plications of its contents
for bank liqu idity -fu nding arrangem ents and liqu idity reporting.
A signifi cant aspect of Basel III is a new liqu idity m easu rem ent
m etric k now n as the net stable fu nding ratio (NSFR).
The stated objectiv e of the NSFR is to encou rage m ore m ediu m -term
fu nding; the m etric itself highlights the lev el of long-term fu nding
com pared w ith short-term liabilities. At this stage, no lim it for the
NSFR has been set, and su ch a lim it is u nlik ely ; how ev er, regu lators
are ex pected to com pare each bank ’s fi gu re against its peer grou p
av erage and range. At the tim e of w riting, the ex act calcu lation of the
m etric has not been specifi ed; the au thor agrees w ith either of tw o
su ggestions pu t forw ard by the British Bank ers Association (BBA) as
part of its response to the BCBS proposals.
Certainly , the NSFR is not a m etric on w hich one cou ld set a ‘one-
size-fi ts-all’ lim it. As su ch, it is ex pected that su perv isors w ill v iew it
as part of a set of other m etrics before determ ining regu latory
com pliance. How ev er, bank senior m anagem ent need to be aw are
of it, and stru ctu re their liabilities w ithin an acceptable bou nd for
regu latory com pliance.
The BBA has su ggested either of the follow ing defi nitions for
calcu lation of the NSFR:
Capital plus term fu nding w ith residu al m atu rity ov er 1 y ear plus
non-w holesale fu nding divided by assets not m ark etable w ithin
1 y ear:
Capital Term fu nding 1 y ear Retail fu nding
Assets 1 y ear
Giv en that the problem du ring the crisis w as one of ov erreliance
on short-term (<1 y ear) w holesale fu nding, an alternativ e
calcu lation of the m etric cou ld be by u sing a form u la of the form :
Unsecu red w holesale fu nding 1 y ear
Total deposits Debt secu rities in issu e Capital
In essence. the pu rpose of the NFSR is to control the lev el of m atu rity
transform ation that an institu tion u ndertak es .
With regard to liqu idity m easu rem ent reporting, the BCBS has
proposed a consis tent set of m onitoring m etrics for all fi rm s. The
pu rpose of this is to assist su perv isors across ju risdictions in look ing
at liqu idity risk in global bank s, and creating a com m on langu age,
thereby redu cing the risk of m is interpretation of inform ation by
bank boards and regu lators. It w ill also hav e the added adv antage
of redu cing sy stem costs in reporting the liqu idity risk being ru n by
su ch entities.
We discu s sed a range of reports in Chapter 8. Som e of these are in the
BCBS list, inclu ding:
(i) Loan-to-deposit ratio.
(ii) Cu m u lativ e liqu idity m odel – a forw ard-look ing m odel of
infl ow s , ou tfl ow s and av ailable liqu idity , accu m u lated for a 12-
m onth period. It recognizes and predicts liqu idity stress points
on a cash basis . This w ill also inclu de 1-w eek ,
1-m onth and 3-m onth liqu idity ratios.
(iii) Liqu idity risk factor (also k now n as m atu rity transform ation) –
the av erage tenor of assets to av erage tenor of liabilities.
(iv ) Inter-entity fu nding report for grou p and consolidated bank ing
entities.
(v ) Pricing data.
(v i) Cu rrency analy sis.
(v ii) Retail and corporate fu nding lev els.
(v iii) Long-term -fu nding/core-fu nding ratio.
(ix ) Liqu id asset bu ffer.
(x ) Su rv iv al horizon.
(x i) Dom estic qu antitativ e ratios.
(x ii) Sy stem s and controls qu estionnaire or qu alitativ e self-
assessm ent.
In addition, there are a nu m ber of other reports that the au thor

considers to be u sefu l:
(i) A fu nding concentration report indicates the ex tent of reliance

on single sou rces of fu nds – for ex am ple, the top-fi v e biggest
single sou rces , by sector and indiv idu al fi rm /cu s tom er. It also
ascertains w hether the lim its set by the bank ex ceed m ore
than, say , 10% of fu nds from one single sou rce.
(ii) Report on the am ou nt of fu nding capacity that ex ists after
tak ing into accou nt the headroom requ ired to su rv iv e a
stress ev ent (w hether fi rm specifi c or m ark et w ide), on the
ex tent to w hich ex isting liabilities and assets are rolled ov er
and on the am ou nt of new bu sines s pu t on, ov er a giv en period
of tim e. We call this m etric the ‘su rplu s fu nding capacity ’ of a
bank .
(iii) A w eek ly qu alitativ e report that prov ides a descriptiv e
su m m ary of any m aterial detrim ental changes to the abov e
m etrics – for ex am ple, it ex plains signifi cant changes in the
1-w eek and 1-m onth liqu idity ratios, the cash and liqu idity gap
in the cu m u lativ e liqu idity m odel, the liqu idity risk factor,
intergrou p borrow ing/lending position, etc.
A bank that reports u sing the fu ll su ite of m etrics listed abov e w ill be
able to giv e a transparent pictu re of its liqu idity position, w hich is
essential to ensu ring orderly regu latory su perv ision.
Bank senior m anagem ent and boards m u st incorporate the

constitu ent elem ents that m ak e u p the BCBS proposals, as they
w ill form an essential part of the new bank m odel du ring the nex t
10 y ears.
The liquid asset buffer

If one rev iew ed bank balance sheets from the 1950s throu gh to the
1990s, it w as com m on practice to observ e that – on the asset side –
part of it w ou ld be com prised of gov ernm ent bonds. That this prac-
tice fell into disu se refl ects the think ing of the last 10–15 y ears: that
m ark et liqu idity cou ld be tak en for granted and bank ‘liqu idity ’
portfolios cou ld be held in the form of higher y ielding bank bonds
(MTNs and FRNs).
Under the FSA’s Policy Statement 09/16, a ‘liqu id asset bu ffer’ (LAB)
is now m andatory for all UK-regu lated bank s. It is to be recom -
m ended as a standard part of all bank bu sines s m odels – irrespectiv e
of ju risdiction – becau se of the obv iou s risk m itigation im pact of
doing so. Becau se sov ereign bonds pay less than other secu rities, the
im plication of this change is clear: RoE w ill be low er.
Using FSA requ irem ents as a tem plate, a bank shou ld adopt the basic
operating m odel for its LAB by :
Requ iring all branches to hold bu ffers of liqu id assets. The

ex pectation behind this think ing is that LAB assets w ill retain
both v alu e and liqu idity in a stressed env ironm ent. The ev idence
for this is strong: in October and Nov em ber 2008, the only assets
that rem ained liqu id, and acceptable for repo, w ere G7 sov ereign
secu rities. Bank CDs, FRNs, corporate bonds and stru ctu red
fi nance secu rities all becam e illiqu id and/or w ere no longer
acceptable as collateral.
Mak ing the central bank eligibility of the LAB asset irrelev ant.
By fu nding the LAB by long-term ( 90 day ) fu nds inclu ding retail
and w holesale fu nds – and not fu nding in repo. This is to ensu re
that the bonds can act as a tru e bu ffer of liqu idity , able to be sold
or repoed if fu nding becom es stressed for the bank .
The LAB for m ost bank s in Western ju risdictions w ou ld be ex pected

to be com prised of the follow ing (this is direct from the FSA
docu m ent):
‘Highly liqu id, high-qu ality gov ernm ent debt instru m ents su ch as
gilts, plu s bonds rated at least Aa3 issu ed by the cou ntries of the
Eu ropean Econom ic Area (EEA), Canada, Japan, Sw itzerland and
the United States; reserv es held w ith the Bank of England’s
reserv e schem e and w ith the central bank s of the U.S, the
EEA, Sw itzerland, Canada and Japan. Designated m u ltilateral
dev elopm ent bank s inclu ding
– African Dev elopm ent Bank
– Asian Dev elopm ent Bank
– Cou ncil of Eu rope Dev elopm ent Bank
– Eu ropean Bank for Recons tru ction and Dev elopm ent
– Eu ropean Inv estm ent Bank
– Inter-Am erican Dev elopm ent Bank
– International Bank for Recons tru ction and Dev elopm ent
– International Finance Corporation
– Islam ic Dev elopm ent Bank
– Nordic Inv estm ent Bank .’
It is fairly clear that the LAB at a bank m u st ideally hold only

high- qu ality assets, or otherw ise be com prised of cash deposits
at the central bank . Becau se m any eligible bonds held in an LAB
w ou ld pay low er than LIBOR, bank s w ill w ant to hold su ch bonds
that are longer dated so as not to lose m oney on the portfolio, if they
are fu nded shorter tenor in a positiv e-sloping y ield cu rv e env iron-
m ent.
The FSA ex pects a fi rm to tu rn ov er its liqu idity bu ffer on a regu lar

basis, either throu gh the sale of assets or v ia repo. As w e noted abov e,
the portfolio cannot be fu nded in repo. It m u st be fu nded u sing
u ns ecu red fu nds, retail deposits or term fu nds – that is, ov er
90-day m atu rity . The size of the bu ffer is a k ey point. The ex act
proportion of a bank ’s balance sheet that has to be held in the form of
an LAB is a fu nction of the ty pe of institu tion and the stru ctu re of its
fu nding.
The FSA’s calcu lation su ggests that a bank w ill hav e to hold the
aggregate total of its 3-m onth fu nding base as a liqu id bu ffer. In other
w ords, the m ore longer term fu nds a bank has, the sm aller its bu ffer.
Essentially , the calcu lation of how m u ch of a bu ffer a bank needs to
hold is a fu nction of how m u ch short-dated (0–90 day ) w holesale
fu nding a bank has. The higher the short-dated w holesale fu nding of
a bank , the larger its LAB.
Conclusions and recom m endations

A neu tral observ er of the w orld’s econom ic sy stem w ou ld conclu de
fairly qu ick ly that fi nancial m ark ets, and bank s, are indis pensable
parts of the econom y and societal w ell-being. It is v ital therefore
that any regu latory sy stem shou ld incorporate the m eans of
enforcing stability in the bank ing m ark et. It shou ld also allow
for fi nancial m ark et innov ation becau se it has been largely
throu gh this that m any of the benefi ts of fi nance hav e been m ade
av ailable to the w ider popu lation. Bu t the k ey priority is effectiv e
regu lation so that – ev en if indiv idu al bank s are forced into
liqu idation – m ark et stability is m aintained. In other w ords,
regu lation m u st not only seek to preserv e stability bu t also recognize
that the m ain bu sines s of bank s inv olv es tak ing risk : the act of
m atu rity transform ation, the cornerstone of bank ing, creates risk
ex posu re.
Bank senior m anagem ent and boards shou ld accept that the
institu tions they ru n are piv otal parts of society and that in
the post-cris is era they w ill be closely regu lated. Contribu ting to
the stability of the m ark et is as im portant an objectiv e for a board as
is achiev ing shareholder RoE targets. To this end, an u nderstanding
and appreciation of m ark et stability is v ital. In the fi rst instance,
increasing bank capital lev els is a necessary thou gh not necessarily
su ffi cient m eans of ensu ring a stable bank ing sy stem : liqu idity
m anagem ent is ju st as im portant. In this regard, the UK FSA’s
requ irem ent that all UK-regu lated bank s m u st m aintain an LAB
is correct. Forcing ev ery bank to inv est a proportion of their
assets in cash, central bank deposits and liqu id AAA-rated sov ereign
secu rities is the best insu rance protection against fu tu re liqu idity
crises.
We believ e all bank s shou ld adopt this approach. The ex act

proportion of the balance sheet that shou ld be placed in the LAB
is a fu nction of the liqu idity gap that the bank ru ns as w ell as the
div ersity and secu rity of its fu nding arrangem ents . One form of LAB
is best bu sines s practice, and all bank s shou ld seek to pu t it in place.
In itself this is not a new su ggestion; a tru ly liqu id portfolio w as
com m onplace in bank s arou nd the w orld 15 or 20 y ears ago.
How ev er, bank s started to u nilaterally relax their ow n requ irem ents
and rem ov e liqu idity portfolios, or m ov e them into assets that w ere
not tru ly liqu id (su ch as bank FRNs), to the point w here su ch
portfolios had becom e rare ev en in su pposedly conserv ativ e institu -
tions su ch as the UK’s bu ilding societies . It is ev ident that the

prev ailing orthodox y has now gone fu ll circle.
Bank boards shou ld seek to sim plify their capital stru ctu res in the
interests of transparency and inv estor com fort. The sim plest stru c-
tu re m ay w ell be the m ost effi cient, w ith a liability base com prised
of pu re equ ity , retained profi ts, senior u nsu bordinated bonds and
deposits. Deposits are part of a cou ntry ’s deposit gu arantee
schem e, so su ch a stru ctu re leav es no am bigu ity abou t w hat
stak eholders are at risk shou ld the bank fail.
The natu re of bank liqu idity m anagem ent has been transform ed,
althou gh m any of the ‘new ’ requ irem ents in regim es – su ch as
those im plem ented by the FSA – are m ore of a retu rn to basics
than actu al new practices. The new bank bu s iness m odel for the
nex t 10 or 20 y ears w ill incorporate these practices, w ith boards
recom m ended to pay close attention to their bank s’ liability stru c-
tu res. The basic tenets of the new liability m odel is less reliance on
w holesale fu nding, less reliance on short-term fu nding, a m ore
div ersifi ed fu nding base, and genu ine self-su ffi ciency in fu nding.
Under this new m odel, bank s w ill be considerably less lik ely to
su ffer failu re at the tim e of the nex t m ark et crash or sy stem ic
stres s ev ent.
REFERENCES
Bank of England (2009) Financial Stability Report, Issu e No. 26, Decem ber.
Chou dhry , M. (2007) Bank Asset and Liability Management, John Wiley &
Sons (Asia) Pte Ltd.
By Moorad Choudhry
Chapter
10
BANK REGULATORY
CAPITAL
T he capital allocation requ irem ents of a fi nancial institu tion are

behind ov erall bank ing strategy . Ass et allocation decisions are
infl u enced to a great ex tent by the capital considerations that su ch
allocation im plies. Low er capital requ irem ents for deriv ativ es
ex plain to a great ex tent w hy deriv ativ es are u sed by bank s and
corporates instead of cash produ cts. This is as tru e of the m oney
m ark ets as it is of the bond m ark ets. For that reason, a book on global
m oney m ark ets m u st cov er bank ing itself, otherw ise it w ill be
incom plete. An u nderstanding of bank ing is not possible w ithou t
an u nderstanding of one of its k ey aspects: regu latory capital.
For instance, a k ey aspect of the m oney m ark ets inv olv es secu ritized
produ cts – for ex am ple, asset-back ed com m ercial paper. Prev iou sly ,
one of the k ey m otiv ations behind secu ritization w as the
requ irem ent to obtain capital relief. This led to m ortgages, trade
receiv ables and other assets being secu ritized. We can see that it
is v ital to u nderstand the im plications of capital costs. Moreov er, the
issu e of cost of capital m u st also tak e into accou nt the regu latory
capital im plications of any asset allocation tak en by a trading desk .
Money m ark et participants m u st k now abou t regu latory capital
issu es – w hether they trade CDs, bills, repos, FRNs, ABCPs – or
they w ill not fu lly u nderstand the cost of their ow n capital and hence
retu rn on capital.
Bank ing regulatory capital requirem ents

Bank s and fi nancial institu tions are su bject to a range of regu lations
and controls, a prim ary one of w hich is concerned w ith the lev el
of capital that a bank holds and w hether this lev el is su ffi cient
to prov ide a cu shion for the activ ities that the bank enters into.
Ty pically , an institu tion is su bject to the regu latory requ irem ents
of its dom estic regu lator, bu t it m ay also be su bject to cross-border
requ irem ents su ch as the Eu ropean Union’ s capital adequ acy direc-
tiv e. 1 A capital requ irem ents schem e proposed by a com m ittee of
central bank s acting u nder the au spices of the Bank for International
Settlem ents (BIS) in 1988 has been adopted u niv ers ally by bank s
In the UK, bank ing regu lation is now the responsibility of the FSA, w hich
took ov er from the Bank of England in 1998. In the US, bank ing su perv ision
is condu cted by the Federal Reserv e; it is com m on for the central bank to be
a cou ntry ’s dom estic bank ing regu lator.
BANK REGULATORY CAPITAL 283
arou nd the w orld. These are k now n as the BIS regu latory requ ire-
m ents or the Basel capital ratios, from the tow n in Sw itzerland w here
the BIS is based.2 Under the Basel requ irem ents all cash and off-
balance-sheet instru m ents in a bank ’s portfolio are assigned a risk
w eighting, based on their perceiv ed credit risk , w hich determ ines the
m inim u m lev el of capital that m u st be set against them .
A bank ’s capital is, in its sim plest form , the difference betw een the
assets and liabilities on its balance sheet, and is the property of
the bank ’s ow ners . It m ay be u s ed to m eet any operating losses
incu rred by the bank , and if su ch losses ex ceed the am ou nt of
av ailable capital then the bank w ill hav e diffi cu lty in repay ing li-
abilities, w hich m ay lead to bank ru ptcy . How ev er, for regu latory
pu rposes capital is defi ned differently ; again, in its sim plest form
regu latory capital is com prised of those elem ents in a bank ’s balance
sheet that are eligible for inclu s ion in the calcu lation of capital
ratios. The ratio requ ired by a regu lator w ill be that lev el deem ed
su ffi cient to protect the bank ’s depositors. Regu latory capital in-
clu des equ ity , preference shares and su bordinated debt, as w ell as
general reserv es. The com m on elem ent of these item s is that they are
all loss absorbing, w hether this is on an ongoing basis or in the ev ent
of liqu idation. This is cru cial to regu lators, w ho are concerned that
depositors and senior creditors are repaid in fu ll in the ev ent of
bank ru ptcy .
The Basel ru les on regu latory capital originated in the 1980s, w hen
there w ere w idespread concerns that a nu m ber of large bank s
engaged in cross-border bu sines s w ere operating w ith insu ffi cient
capital. The regu latory au thorities of the G10 grou p of cou ntries
established the Basel Com m ittee on Bank ing Su perv ision. Its 1988
pu blication, International C onvergence on C apital Management
and C apital Standards, set proposals that w ere adopted by
regu lators arou nd the w orld as the ‘Basel ru les ’. The Basel Accord
w as a m ethodology for calcu lating risk , w eighting assets according
to the ty pe of borrow er and its dom icile. The Basel ratio 3 set a
m inim u m capital requ irem ent of 8% of risk -w eighted assets.
BIS (1988) International C onvergence of C apital Measurement and

C apital Standards, Basel Com m ittee on Bank ing Regu lations and
Su perv isory Practice, Ju ly .
Also k now n as the ‘Cook e ratio’ after the Chairm an of the Basel
Com m ittee at the tim e, Peter Cook e.
In this chapter w e su m m arize the essential elem ents of the cu rrent

requ irem ents, now referred to as Basel II, and then discu s s the BIS
proposals now k now n as Basel III.
Capital adequacy requirem ents

The origin of the cu rrent capital adequ acy ru les w as a desire by
bank ing regu lators to strengthen the stability of the global
bank ing sy stem as w ell as harm onize international regu lations.
The 1988 Basel Accord w as a signifi cant adv ancem ent in bank ing
regu lation, setting a form al standard for capitalization w orldw ide.
It w as su bsequ ently adopted by national regu lators in ov er 100
cou ntries. The Basel ru les hav e no regu latory force as su ch;
rather, indiv idu al cou ntry regu latory regim es adopt them as a
m inim u m requ ired standard. This m eans that there are slight v aria-
tions on basic Basel requ irem ents arou nd the w orld, of w hich the
Eu ropean Union’s capital adequ acy directiv es are the best ex am ple.
Basel I rules
The BIS ru les set a m inim u m ratio of capital to assets of 8% of the
v alu e of the assets. Ass ets are defi ned in term s of their risk , and it is
weighted risk assets that are m u ltiplied by the 8% fi gu re. Each asset
is assigned a risk w eighting, w hich is 0% for risk -free assets su ch as
certain cou ntry gov ernm ent bonds and u p to 100% for the highest
risk asset su ch as certain corporate loans. So, w hile a loan in the
inter-bank m ark et w ou ld be assigned a 20% w eighting, a loan of
ex actly the sam e size to a corporate w ou ld receiv e the highest
w eighting of 100% .
Form ally , the BIS requ irem ents are set in term s of the ty pe of capital
that is being set aside against assets. International regu lation (and
UK practice) defi nes the follow ing ty pes of capital for a bank :
Tier 1 – perpetu al capital, capable of absorbing loss throu gh the
non-pay m ent of a div idend. This is shareholders’ equ ity and also
non-cu m u lativ e preference shares .
U pper Tier 2 – this is also perpetu al capital, su bordinated in
repay m ent to other creditors; it m ay inclu de, for ex am ple,
u ndated bonds su ch as bu ilding society PIBS, and other
irredeem able su bordinated debt.
Lower Tier 2 – this is capital that is su bordinated in repay m ent to
other creditors, su ch as long-dated su bordinated bonds .
The lev el of capital requ irem ent is giv en by :

Tier 1 capital
4%
Risk -adju sted ex posu re
10 1
Tier 1 Tier 2 capital
8%
Risk -adju sted ex posu re
The ratios in equ ation (10.1) therefore set m inim u m lev els. A bank ’s
risk-adjusted exposure is cash risk -adju sted ex posu re together w ith
risk -adju sted off-balance-sheet ex posu re. For cash produ cts on the
bank ing book , capital charge calcu lation (risk -adju sted ex posu re) is
giv en by :
Principal v alu e Risk w eighting Capital charge 8%
calcu lated for each instru m ent.
The su m of the ex posu res is tak en. Firm s m ay u se netting or portfolio
m odelling to redu ce the total principal v alu e.
Capital requ irem ents for off-balance-sheet instru m ents are low er
becau se for these instru m ents the principal is rarely at risk . Interest
rate deriv ativ es su ch as forw ard rate agreem ents (FRAs) of less than
1 y ear’s m atu rity hav e no capital requ irem ent at all, w hile a long-
term cu rrency sw ap requ ires capital of betw een 0.08% and 0.2% of
the nom inal principal.
The BIS m ak es a distinction betw een banking book transactions as
caried ou t by retail and com m ercial bank s (prim arily deposits and
lending) and trading book transactions as carried ou t by inv estm ent
bank s and secu rities hou s es. Capital treatm ent differs betw een
bank ing and trading book s .
A prim er on Basel II
The Basel II ru les w ere pu blished in fi nal form in Ju ne 2004. 4 This
chapter concentrates on the essentials behind the m ain ru lings
contained in the BIS docu m ent – these are im portant from an
ALM strategis t’s point of v iew .
The actu al title of the docu m ent, pu blished by the Basel Com m ittee on
Bank ing Su perv ision of the Bank for International Settlem ents on 26 Ju ne
2004, is International C onvergence of C apital Measurements and C apital
Standards.
The aim of Basel II w as to align econom ic and regu latory capital m ore
closely than Basel I. It introdu ces three different approaches that a
bank can adopt to achiev e this: the standardized approach, w hich is
not far rem ov ed from the cu rrent Basel I fram ew ork bu t w hich
applies m ore risk -w eighting categories and u ses form al credit
ratings; and the fou ndation and adv anced internal-ratings-bas ed
(IRB) approaches, w hich are m ore com plex and allow for a bank to
u se its ow n risk m odels and risk ex posu re data in line w ith the Basel
II fram ew ork . Im plem entation of the new ru les shou ld resu lt in
changes in certain bank and ALM activ ity , w ith certain produ cts
and sectors seeing greater activ ity and other areas less, as capital is
realigned and bank s seek to m eet adju sted target rates of retu rn.
Overview
Giv en that the prim ary objectiv e behind Basel II is to better align
econom ic w ith regu latory capital, w e conclu de that bank ing activ ity
ex hibiting low econom ic risk w ill attract a low capital charge.
Su ch activ ity m ight inclu de residential m ortgages and high-grade
corporate lending. By the sam e tok en, bu sines s that prev iou sly w as
of interest to bank s becau se regu latory treatm ent seem ed less
onerou s than perceiv ed econom ic risk , su ch as low -rated secu ritiza-
tion tranches and non-OECD cou ntry lending, shou ld becom e less
attractiv e. Follow ing this logic, bank s that hav e a high proportion of
low er risk bu sines s, su ch as com m ercial and retail bank s, w ill fi nd
that their capital charge has redu ced. The m odel-based approaches –
the fou ndation and adv anced IRB – requ ire less capital to be held
com pared w ith the standardized approach. Im planting these ap-
proaches w ill call for a large inv estm ent in risk m anagem ent
m odels and internal data sy stem s – som ething only the larger
bank s can afford. Thu s, an adv antage is presented to large bank s
ov er sm all bank s straight aw ay .
Three-pillar approach
The cornerstone of the Basel II ru les is the three-pillar approach.
Thes e are m inim u m capital requ irem ents, su perv isory rev iew and
m ark et discipline. A general description of them follow s.
Minimum capital requirements. The objectiv e of these is to produ ce
a closer link betw een econom ic and regu latory capital. The u nder-
ly ing idea is to rem ov e any possibility of regu latory capital arbitrage,
w hich w as com m on u nder Basel I. There is a m ore tailored regim e,
w ith m ore specifi c targeting of indiv idu al credits rather than the
broad-bru sh approach of Basel I w hich targeted w hole asset class es.
An ex am ple of this w as the 20% risk w eighting giv en to OECD
cou ntry bank s, w hich m eant som e low -rated bank s requ ired the
sam e capital set-aside as v ery highly rated bank s. The 100% risk
w eighting for all corporates, regardless of their credit qu ality or
cou ntry of incorporation, w as another ex am ple of this. Also u nder
this pillar w as a m ore contentiou s issu e, a new capital charge for
operational risk . This w ou ld cov er the risk of IT break dow n as w ell
as risk s su ch as frau d and trading irregu larity .
The defi nition of bank capital rem ains as it w as u nder Basel 1, and
the m inim u m capital ratios of 4% for Tier 1 and 8% for total capital
also rem ain in place. So, Pillar 1 – and Basel II as a w hole – is
concerned only w ith the denom inator of the capital ratio calcu lation
as established u nder Basel 1 – not the nu m erator w hich rem ains
u nchanged.5
Supervisory review process. This is the focu s of Pillar 2 and cov ers
national regu lators’ rev iew s of bank capital assessm ent m odels . It
describes the process by w hich the regu lator sets m inim u m capital
requ irem ents that ex ceed those ou tlined in Pillar 1, w ith the ex act
requ irem ents being a fu nction of the risk profi le of each bank . Bank s
m u st also asses s their credit concentration risk s and stres s-test them
u nder v ariou s conditions.
Enhanced public disclosure. Pillar 3 requ ires bank s to pu blis h
their risk -w eighting calcu lations , capital break dow n and capital
adequ acy .
Approaches to credit risk

The Basel II ru les can be im plem ented u nder three alternativ e
approaches: standardized, fou ndation IRB and adv anced IRB. Thes e
can be briefl y described as follow s:
Standardized approach. The m ost straightforw ard to apply , w ith
risk w eights being assigned according to asset class or form al
credit ratings. The assets are described as residential m ortgages,
corporate loans, and so on.
There is a slight change to the nu m erator in the ratio u nder Basel II in

circu m stances w here dedu ctions of capital for certain asset classes m u st be
m ade, bu t this w ill not apply to all bank s.
Foundation IRB. Under the fou ndation IRB approach, capital

calcu lation is m ade after the bank itself sets defau lt probabilities
for each class of assets. The bank assigns probabilities of defau lt
(PD) to each asset class , or each asset in accordance w ith credit
rating. Using the Basel II gu idelines it then sets param eters for
loss giv en defau lt (LGD), ex posu re at defau lt (EAD) and m atu rity
(M). These inpu ts are then u sed to calcu late the risk w eights for
each asset class u sing the Basel II capital calcu lation form u la.
Fou ndation IRB m ay be u sed as a stepping stone before im ple-
m entation of the adv anced IRB m ethodology , or retained as the
calcu lation m ethod in its ow n right.
Advanced IRB. Under the adv anced IRB approach, a bank w ill
calcu late risk w eights u sing its ow n param eters, w hich are
arriv ed at from its ow n defau lt data and internal m odels.
Under the IRB approach bank s m ay u se their ow n data, thou gh –

signifi cantly – it m u st inclu de data for PD, LGD and EAD. Their ow n
m odel can be u sed to calcu late risk w eights, w hich is then adju sted
by a scaling factor. In practice, this m eans a scaling factor of 1.06 w ill
be applied. Note that a bank m u st adopt the sam e approach for both
its bank ing book and its trading book .
The m ajority of bank s, especially those ou tside Eu rope, are ex pected

to em ploy the standardized approach. Sm aller bank s w ith ex tensiv e
retail and m ortgage bu s iness are also ex pected to adopt the standard-
ized approach. Only the largest bank s are ex pected to adopt the
adv anced IRB approach, w hich requ ires signifi cant inv estm ent in
internal sy stem s. Bank s that w ish to im plem ent the adv anced IRB
approach m u st seek su perv isory approv al of their sy stem s and
m odels from their national regu lator.
Operational risk
Basel II introdu ced a capital set-aside to cov er operational risk –
a contentiou s departu re from the requ irem ents of Basel I. Bank s
are requ ired to calcu late a capital charge for operational risk ,
separate from the capital charge for credit risk . Each approach has
its ow n calcu lation m ethod. The general calcu lation is that a
bank m u st apply 15% of its av erage rev enu e ov er the last 3 y ears
– rev enu e is defi ned as net interest incom e (NII) plu s non-interest
incom e.6 Under the standardized approach a bank m ay calcu late its
ow n lev el of operational risk , per bu sines s line, and apply the capital
charge based on this risk ex posu re. The charge itself can then lie
w ithin a 12% to 18% range, rather than the u niform 15% lev el.
Under the adv anced IRB approach a bank w ill calcu late its ow n
operational risk lev el and then apply its ow n capital charge, u nder
BIS gu idelines of cou rse. This enables a bank to set low er operational
risk charges for certain bu sines s lines , w here it can show that risk
ex posu re is low er.
Table 10.1 is a su m m ary of the m ain differences betw een Basel I and
II by asset class. Certain sectors, su ch as residential m ortgages and
high-credit-rated corporate lending, gain su bstantially u nder the new
regim e, w hereas som e bu sines ses su ch as fu nd m anagem ent, w hich
prev iou sly attracted no charge, now carry an operational risk charge.
Im pact on specific sectors

To illu strate Basel II fu rther, w e consider it w ith regard to specifi c
selected asset classes. One can gain som e idea of the objectiv es of
the new ru les by look ing at their im pact on different bu sines s lines .
We rev iew sov ereigns fi rst, follow ed by bank assets, stru ctu red
fi nance secu rities, corporates and credit deriv ativ es.
Sovereign business
As w as the case w ith all asset classes, the treatm ent of sov ereign debt
u nder Basel I w as v ery sim ple. Sov ereigns w ere div ided into OECD
and non-OECD debt.7 OECD sov ereign debt w as risk -w eighted at
0% , w hile non-OECD sov ereigns w ere risk -w eighted at 100% .
Under Basel II there is a deeper distinction, w ith risk -w eighting
Som e national regu lators hav e specifi ed that a bank m ay tak e av erage
v olu m e of bu siness, su ch as v olu m e of assets, ov er the last 3 y ears rather
than rev enu es.
The m em ber cou ntries of the Organization for Econom ic Cooperation and
Dev elopm ent (OECD) are Au stralia, Au stria, Belgiu m , Canada, the Czech
Repu blic, Denm ark , Finland, France, Germ any , Greece, Hu ngary , Iceland,
Ireland, Italy , Japan, Lu x em bou rg, Mex ico, Netherlands, New Zealand,
Norw ay , Poland, Portu gal, Slov ak ia, Sou th Korea, Spain, Sw eden,
Sw itzerland, Tu rk ey , the UK and the US.
290
Table 10.1 Com paris on of regim e change from Basel I to Basel II – risk w eights
Asset class Basel I Basel II Notes
Standardized IRB a
(% ) (% ) (% )
Sov ereign 0 (OECD) 0–150 b 0–400 New regim e is essentially rating based. 100%
risk w eighting for u nrated sov ereigns. Low er
rated OECD sov ereigns attract higher charges,
w hereas high-rated non-OECD sov ereigns now
attract low er charges
100 (non-OECD)
Bank sector 20 (OECD) 20–150 b 6–400 There are tw o approaches, either (i) one rank
low er than sov ereign rating or (ii) based on
bank ’s ow n credit rating
100 (non-OECD) Unrated bank s carry 50% w eighting. Bank s
rated A to BBB attract a higher charge of 50%
from 20% u nder the old regim e
Retail
– Mortgages 50 35 13–227 Bank s w ith large and/or high-qu ality m ortgage
book s w ill hav e an incentiv e to m ov e to IRB
– Credit card, etc. 100 75 10–227 Ov erdu e u nsecu red loans are w eighted at
100–150% u nder the standardized approach

Corporate loans 100 20–150 14–400 Under IRB there is m ore fav ou rable teatm ent for
inv estm ent-grade rated loans. Under the
standardized approach there is a gain for certain
su binv estm ent-grade loans and also,
paradox ically , for u nrated lending. The latter
attract 100% u nder the standardized approach
Sm all/m ediu m enterprises 100 100 11–198 Certain lending to sm all corporates
(SMEs) ( EUR50 m illion annu al sales) gains adv antages
u nder Basel II
Stru ctu red fi nance 100 20–1,250 7–1,250 There is a dedu ction from capital for tranches
(ABS, etc.) 50 (AAA/AA-rated rated below B . There is fav ou rable treatm ent
BANK REGULATORY CAPITAL
RMBS) for senior tranches, w hich attract low er charges

com pared w ith Basel I. This m ay resu lt in
increased dem and for senior tranches of ABS/
MBS/CDO. There is a higher charge for
su binv estm ent-grade tranches
Operational risk 0 15 12–18 A new charge, w hose effect is to incease ov erall
capital charges for m ost bank s. Biggest im pact
on bu siness lines in bank ing that attract no
regu latory capital charges u nder Basel I
(e.g., fu nd m anagem ent, adv isory serv ices)
Source: BIS, EU CRD.

a
Ranges giv en u nder assu m ptions of w orst case scenarios inclu ding 50% LGD and 10% PD.
b
There is redu ced risk w eighting if the ex posu re is denom inated, and fu nded, in the bank ’s dom estic cu rrency .
291
Table 10.2 Basel II sov ereign debt risk

w eightings (standardized approach)
Basel I Basel II
(% ) (% )
OECD 0 AA and abov e 0

Non-OECD 100 A 20
BBB 50
BB to B 100
Below B 150
Unrated 100
Source: BIS.
assigned by credit rating (u nder the standardized approach). This is

show n in Table 10.2.
The IRB approaches u se bank s’ ow n internal m easu res of risk . Under

the standardized approach, form al credit ratings from ex ternal credit
asses sm ent institu tions (ECAIs) assu m e a high im portance. The BIS
docu m ent describing Basel II states that if a cou ntry carries a rating
each from S&P’s , Moody ’s and Fitch’ s, and one of these is low er than
the other tw o, then the higher can be assu m ed. For a bank holding
the debt of a cou ntry lik e China (w hich is rated A/A2/A ) this ru le
has no im pact; how ev er, for a bank holding the debt of Malay sia
(w hich is rated A/BBB/A), this is signifi cant. It m eans that the bank
can tak e the tw o higher ratings, w hich enable it to apply a 20% risk
w eighting. This is considerable com pared w ith a Basel I w eighting of
100% .
An effectiv e if sim ple illu stration of the new regim e can be giv en as
follow s: consider a bank holding tw o bonds , each of USD10 m illion
nom inal, issu ed by Sou th Africa and Sou th Korea, respectiv ely .
Under Basel I – tak ing the m inim u m 8% capital requ irem ent –
the capital charges for each are
Sou th Africa gov ernm ent bond capital (10,000,000 100% 8% )

or USD800,000
Sou th Korea gov ernm ent bond capital USD0.00.
Under Basel II’s standardized approach the charges are
Sou th Africa (10,000,000 50% 8% ) or USD400,000

Sou th Korea (10,000,000 50% 8% ) or USD400,000.
So, in this sty lized ex am ple the im pact is qu ite signifi cant. The
m ak eu p of gov ernm ent bond portfolios in bank s w ill be rev iew ed
and heav ily infl u enced by each sov ereign credit ECAI. As capital
charges rise for certain borrow ers com pared w ith others, those so-
v ereigns that su ffer an adv erse im pact in term s of the capital that a
bank inv estor is requ ired to hold against them m ay fi nd their
issu ance y ields rise. It is not necessarily em erging m ark et sov ereigns
that w ill be so im pacted. Italy is cu rrently rated at A by S&P’s
(althou gh it is rated Aa2 by Moody ’s and AA by Fitch’ s). If one of
the other agencies also effects a dow ngrade to Italian sov ereign debt,
then su ch debt w ill lose its 0% risk w eighting u nder Basel II’s
standardized approach ru les. This point also highlights the adv an-
tage of adopting IRB ru les. Under fou ndation IRB, cou ntries su ch as
Italy and Greece, w hich w ill or m ay attract a 20% w eighting u nder
the standardized approach, w ill probably be w eighted at 0% u nder
bank s’ ow n PD v alu es for sov ereign debt. How ev er, there is no dou bt
that higher rated non-OECD sov ereigns w ill gain u nder Basel II and
m ay w ell see their bond y ields spread narrow . Less clearcu t, bu t still
a strong possibility , is that low er rated OECD m em bers w ill see their
debt attract a higher charge.
D escription of calculation
Althou gh w e are describing the calcu lation for sov ereign assets here,
m u ch of the calcu lation fram ew ork for Basel II is the sam e for
corporates. Under Basel II the standardized approach applies risk
w eights in accordance w ith asset credit rating, as show n in Table
10.2. Under the IRB approach bank s that m eet m inim u m specifi ed
requ irem ents and hav e obtained their regu lator’s approv al can u se
their internal estim ates of risk param eters to determ ine their capital
requ irem ents. Thes e param eters are
Probability of default (PD ). This is k ey to the IRB approach. It is

the 1-y ear probability that an obligor w ill defau lt.
Loss given default (LG D ). This is a m easu re of the ex pected
av erage loss that a bank w ill su ffer per u nit of asset or ex posu re
in the ev ent of cou nterparty defau lt. Whereas a borrow er can
only hav e one credit rating and hence only one PD, different
sets of ex posu re to the sam e borrow er m ay hav e different
LGDs – for ex am ple, if one ex posu re is collateralized and
another is not.
Exposure at default (EAD ). This is a m easu re of the ex tent to

w hich a bank is ex posed to a cou nterparty in the ev ent of the
latter’s defau lt. For cash transactions , this am ou nt is the
nom inal am ou nt of the ex posu re. For deriv ativ e transactions
and transactions w ith v ariable draw dow n options, a credit con-
v ersion factor is applied to conv ert notional am ou nts to nom inal
v alu es.
Maturity (M). Generally speak ing, longer dated loans represent
higher credit risk . Up to a point, the longer the m atu rity of an
ex posu re the higher the probability of decrease in its credit
qu ality , hence the higher the PD. Som ew hat cou nterintu itiv ely ,
this effect is higher for better rated entities, becau se the higher
the credit rating the greater the nu m ber of dow nw ard categories,
short of defau lt, there are for the entity to m igrate to. Hence, the
risk w eight in term s of M is actu ally higher.
Foundation IRB. A bank adopting this approach m ay u s e its internal

credit risk -scoring m odel to estim ate PD, 8 bu t m u st u se BIS-
prescribed LCG, EAD and M v alu es. Senior u nsecu red claim s on
corporates, sov ereigns and bank s are assigned a 45% LGD; su b-
ordinated u ns ecu red borrow ings are assigned a 75% LGD. There
is an assigned v alu e of 2.5 for M. For EAD a credit conv ersion
factor of 75% is applied for u ndraw n liqu idity facilities and
u nu s ed credit lines.
Advanced IRB. Bank s that im plem ent the adv anced IRB approach
w ill u se their ow n v alu es for PD, EAD and LGD and calcu late their
ow n M v alu e. Becau se national regu latory au thorities w ill also be
setting their ow n prescribed lev els for these param eters, adopting the
adv anced approach w ill be benefi cial for bank s that believ e their ow n
estim ates w ill be low er than those of the regu lator. The calcu lation
of M is dependent on the cashfl ow s of actu al assets on the book .
Generally , if the M v alu e is below 2.5 then the risk w eight w ill
be low er u nder the adv anced approach than u nder the fou ndation
approach. If M lies abov e 2.5 then the opposite is tru e. The m ax im u m
v alu e for M is 5.0.
Formulae. For all assets not in defau lt, the form u lae for calcu lating
risk w eights and capital requ irem ents u nder both the fou ndation and
There is a m inim u m lev el of 0.03% specifi ed by BIS for corporates and

bank s.
adv anced approaches are:

1 ex p 50 PD 1 ex p 50 PD
R 0 12 0 24 1
1 ex p 50 1 ex p 50
10 2
2
b 0 11852 0 05478 ln PD 10 3
R 05
05
K LGD N 1 R G PD G 0 999
1 R
1
PD LGD 1 M 25 b 10 4
1 15 b
w here
R Correlation;
b Matu rity adju stm ent;
K Capital requ irem ent;
N Cu m u lativ e distribu tion fu nction for a standard norm al
v ariable w ith N 0 1 ;
G z Inv erse cu m u lativ e distribu tion fu nction for a standard
norm al v ariable (i.e., the v alu e of x is su ch that N x z)
and
Risk -w eighted assets RWA K 12 5 EAD
The form u la for K is say ing that – ignoring correlation and m atu rity
factors – the capital requ irem ent represents the difference betw een
loss u nder the w orst case scenario (assu m ed to be an ev ent w ith a
probability less than 0.1% ) and ex pected loss (giv en by PD LGD).
Of cou rse, the correlation param eter is k ey becau se the defau lts of
different obligors are not independent of each other. General m acro-
econom ic factors im pact all obligors, m ore so for higher rated enti-
ties (on the assu m ption that low er rated fi rm s are m ore lik ely to
ex perience diffi cu lty du e to fi rm -s pecifi c issu es rather than the
general state of the econom y ). The correlation param eter v alu e in
the form u la lies betw een 0.12 and 0.24; the v alu e increases from 0.12
for entities as their credit rating increases. The m atu rity adju stm ent
factor b is a correction to allow for the fact that the tenor of the
ex posu re w ill be shorter or longer than the benchm ark v alu e of 2.5.
The standard form u la giv en here is not u sed for assets in defau lt.
For su ch ex posu res the capital requ irem ent is giv en by
m ax 0 LGD PD LGD
w here ex pected loss PD LGD is the bank ’s best estim ate. This
estim ate is u sed to calcu late loan loss prov ision and setoff charges
for each asset in defau lt.
Example illustration9
To help illu strate the new calcu lation ru les , and as an indication of
how capital requ irem ents can be signifi cantly different u nder Basel II
than u nder Basel I, w e present a sty lized ex am ple of tw o sov ereign
assets. Im agine that a bank holds the follow ing tw o sov ereign bonds :
USD100 m illion Tu rk ey 10-y ear, rated BB
USD100 m illion Malay sia 10-y ear, rated A
Under Basel I the regu latory capital requ irem ent for this portfolio is
zero for the Tu rk ey bond, becau se the cou ntry is an OECD m em ber,
and USD8 m illion for the Malay sia bond w hich is 100% risk
w eighted. How ev er, u nder Basel II this requ irem ent changes, w ith
the ex act calcu lation being dependent on the approach being
adopted.
Standardized approach. Under the standardized approach, the
ratings of each sov ereign bond determ ine its risk w eighting. 10 So,
the capital calcu lation is
Tu rk ey USD4 m illion
Malay sia USD1.6 m illion
This highlights a general point on the im pact of Basel II com pared
w ith Basel I: u nder the sim ple standardized approach, asset portfolios
that gain inclu de those of highly rated non-OECD obligations su ch
as China, Chile, Hong Kong and Sou th Africa, w hile portfolios that
w ou ld su ffer higher capital charges w ou ld inclu de OECD m em ber
cou ntries that are low er rated, su ch as Mex ico, Poland, Slov ak ia,
Sou th Korea and, as show n here, Tu rk ey . In ou r ex am ple, the holding
of Tu rk ey sov ereign bonds su ffers a signifi cant increase in capital
charge, w hile the holding of Malay sia sov ereign bonds benefi ts from
a m u ch-redu ced requ irem ent.
The au thor thank s Ram eez Saboow ala for his assistance w ith gathering
data for u se in this section.
In ou r ex am ple there is one u niform rating for each ex posu re. Very
broadly speak ing, if a sov ereign or other entity is rated differently across
different agencies, the low er rating applies.
Table 10.3 Calcu lation param eters
PD Correlation factor M LGD a Risk w eight

(% ) (% )
XXXX 0.34 0.2 2.5 45 66

YYYY 0.15 0.2 2.5 45 41
a
Senior-lev el debt.
Foundation IRB. For this ex am ple w e ex tract statistical data from

debt m ark et prices in Janu ary 2006 (see Table 10.3). As far as PD
v alu es are concerned, these are u nnecessarily sev ere; rating agency
PD v alu es for both cou ntries w ou ld be nearer to zero. 11 How ev er, the
illu stration w ork s better u sing ou r u nrealistic estim ates, w hich
produ ce the risk w eights show n in Table 10.3. The M and LGD
v alu es are those prescribed in the BIS docu m ent for u se in the
fou ndation approach.
Using calcu lated risk w eights, w e produ ce a capital requ irem ent of
Tu rk ey USD5.1 m illion
Malay sia USD3.3 m illion
So, u nder fou ndation IRB w e hav e a still-higher capital charge for
Tu rk ey and a low er requ irem ent for Malay sia. Note that ou r calcu la-
tion, u sing m ark et data from 2006, produ ced different resu lts from
the BIS’s ex am ple calcu lation released at the tim e of the fi nal draft.
Advanced IRB. Under the adv anced IRB approach, as Malay sia has a
low er PD v alu e its im pact is, som ew hat cou nter-intu itiv ely , greater
ov er a longer period than Tu rk ey ’s. This produ ces a greater increase
in capital charge for a 10-y ear ex posu re for Malay sia than for Tu rk ey .
The risk w eight for Malay sia rises from 41% to 66% , w hile that for
Tu rk ey rises from 66% to 100% .
Note that the v alu es arriv ed u nder adv anced IRB are heav ily
infl u enced by the PD, M and LGD param eters u sed. Signifi cant
differences in resu lts can em erge based on w hat v alu es are assigned
for these inpu ts. For ex am ple, rating agency PDs often differ greatly
from credit defau lt sw ap-im plied PD v alu es. In the case of sov ereign
This is signifi cant: at a zero PD there w ou ld be a zero capital requ irem ent
becau se there is no m inim u m lev el of PD for sov ereign ex posu res. For
corporate ex posu res, a m inim u m fl oor PD applies irrespectiv e of rating.
ex posu res – becau se PDs can assu m e zero v alu e – the choice of w hich
nu m ber to u se is signifi cant.
Bank assets
For bank ALM strategy pu rposes, this is perhaps the m ost im portant
asset class to assess w ith respect to the im pact of Basel II. Bank s are
signifi cant holders of short-term and m ediu m -term bank -issu ed debt
and w ill look to rebalance liqu idity portfolios for any ty pes of assets
that are adv ersely affected u nder the new ru les. 12
Note that Basel II does not redefi ne (nor seek to redefi ne) bank
‘capital’. The defi nition of Tier 1 and Tier 2 capital rem ains the
sam e as u nder Basel I. So, a bank holding another bank ’s capital
instru m ents m u st continu e to observ e specifi c ru les , althou gh in
practice there m ight be a possibility of m ore fav ou rable treatm ent in
practice u nder the IRB approach. Essentially , a holding of bank
capital in the form of equ ity or su bordinated debt by another
bank , w hich is greater than the equ iv alent of 10% of the holding
bank ’s ow n capital, is dedu cted from the holding bank ’s capital base
or risk -w eighted at 100% . In other w ords, a m inim u m of 8% capital
w ou ld hav e to be held against an asset com prised of bank capital,
w hether this is Tier 1 equ ity , u pper Tier 2 or low er Tier 2 su b-
ordinated debt. Under the IRB approach in Basel II, there is no
specifi c new treatm ent for bank capital, bu t apply ing the IRB
ru les m ay resu lt in som e bank capital being risk -w eighted at
low er than 100% . We can see how this m ay w ell be the case
w here the instru m ent is issu ed by a strongly rated bank .
Short-term debt
The new ru les for short-term bank debt can be su m m arized as
follow s:
Debts of 1-y ear m atu rity or less are assigned a 20% risk w eighting
assu m ing they are rated at A-1/P-1. 13 Short-term bank debt rated
Bank s hold a large part of their liqu idity book in short-term bank debt
su ch as certifi cates of deposit (CDs), com m ercial paper (CP) and fl oating
rate notes (FRNs).
Note that the highest S&P short-term rating is A-1 , w hile the highest
Moody ’s short-term rating is P-1.
at A-2/P-2 is assigned a 50% w eighting w hile A-3/P-3 paper is

w eighted at 100% .
Very -short-term debt of 3-m onth m atu rity or less that is u nrated,
bu t w hose issu er has a long-term rating equ iv alent to A-3/P-3,
w ill be rated at 20% .
Essentially , it is apparent that v irtu ally all short-term bank paper

w ill continu e to be rated at 20% , w hich is u nchanged from the Basel I
regim e. The preferential treatm ent of v ery -short-term debt, w hich
enables ev en low -rated (A-3/P-3) assets to be w eighted at 20% , is
prescribed in Option 2 of the standardized approach to bank debt (see
Ex am ple 10.1). It is not av ailable u nder Option 1, so bank s that are
requ ired to adopt the latter by their national regu lator w ill not hav e
this fl ex ibility . Under Option 1 short-term assets w ill be rated at
20% , 50% and 100% for A-1/P-1, A-2/P-2 and A-3/P-3 ratings,
respectiv ely . In the ev ent that a sov ereign or bank has three
ratings, the tw o highest ratings w ill apply . Table 10.4 su m m arizes
Option 1 and Option 2 risk w eights.
We can identify certain anom alies that m ay arise u nder this tw o-

alternativ e ru ling. For all assets of ov er 3-m onth m atu rity , there is a
clear difference at the BBB to BBB rating band. Under Option 1 a
bank in that rating range w ou ld be 100% risk -w eighted, w hereas
u nder Option 2 it w ou ld carry only a 50% risk -w eighting. Another
potential anom aly is a BBB-rated bank incorporated in an A-rated
cou ntry : u nder Option 1 it w ou ld carry a 50% w eighting, com pared
w ith a 100% w eighting u nder Option 2. Note also the preferential
treatm ent for v ery -short-term bank debt u nder Option 2.
From Table 10.4 w e conclu de that bank s of low er credit rating bu t

w ho are incorporated in a highly rated cou ntry w ou ld benefi t from
adopting Option 1, w hile in the conv erse case Option 2 w ou ld be
adv antageou s . 14 Note that the UK’s FSA regu latory agency has stated
that Option 2 is the m ore risk sensitiv e of the tw o approaches and
shou ld be the one that is u sed.15
Note that rating agencies do not rate a corporate entity , inclu ding a bank ,
at a higher rating than the rating of its cou ntry of incorporation (althou gh
an equ iv alent rating is possible). Hence, su ch bank s are rare beasts.
C onsultation Paper 189, FSA.
300
Table 10.4 Basel II bank debt capital charge – Options 1 and 2
O ption 1: C entral government risk-weight-based method
Rating of sov ereign AAA to AA A to A BBB to BBB BB to B Below B Unrated

Risk w eight for senior debt 20% 50% 100% 100% 150% 100%
O ption 2: C redit assessment-based method
Rating of bank AAA to AA A to A BBB to BBBB BB to B Below B Unrated

Risk w eight for senior bank debt 20% 50% 50% 100% 150% 50%
Risk w eight for v ery -short-term 20% 20% 20% 50% 150% 20%
senior debt ( 3-m onth m atu rity )
IRB approach
The procedu re for apply ing IRB ru les in both fou ndation and
adv anced form s for bank assets is v irtu ally identical to that u sed
for sov ereign assets. The only signifi cant difference is that a
m inim u m v alu e of 0.03% for the PD param eter m u st be applied
for bank assets w hen calcu lating the risk w eighting. If apply ing
fou ndation IRB, a bank m ay u se its ow n internal credit analy sis
resu lts w hen estim ating the PD param eter (su bject to the 0.03%
m inim u m ), w hile v alu es for the EAD, LGD and M param eters are
set in the BIS gu idelines. Senior u nsec u red bank debt is assigned a
45% LGD v alu e, w ith su bordinated u nsecu red debt giv en a 75%
LGD lev el. The v alu e for M is 2.5. If apply ing adv anced IRB, a
bank m ay u se its ow n internally calcu lated v alu es for PD, EAD,
LGD and M.
Repo agreements and securities lending

A 0% risk w eight is applied to an ex posu re that is collateralized
u nder a repo agreem ent if the cou nterparty is a ‘core m ark et
participant’ ; otherw ise, the risk w eight is 10% . This assu m es that
(i) the loan and the collateral are denom inated in the sam e cu rrency ,
(ii) the position is m ark ed-to-m ark et on a daily basis and m argin
tak en w here necessary and (iii) the transaction tak es place u nder a
standard legal agreem ent su ch as a GMRA.
Any other collateralized ex posu re is also risk -w eighted at 0% ,
prov ided that the collateral is in the form of cash or sov ereign
debt issu ed by a cou ntry that is also risk -w eighted at 0% u nder
the standardized approach and there is a haircu t of at least 20% .
D erivative positions
Bank s are the largest u sers of off-balance-sheet deriv ativ es su ch as
sw aps . Under Basel I bank s calcu lated the credit ex posu re arising
from deriv ativ es trading u sing the ‘cu rrent ex posu re’ m ethod, w hich
entailed tak ing the m ark -to-m ark et v alu e of each position and basing
ex posu re on that. Basel II continu es essentially w ith this approach.
The cou nterparty charge for deriv ativ es transactions is giv en by :
Cou nterparty charge RC Add-on CA r 0 08 10 5
w here
RC Replacem ent cost;
Add-on Potential fu tu re ex posu re;
CA Collateral v alu e;
r Cou nterparty risk w eight.
Note that this only applies to ov er-the-cou nter (OTC) deriv ativ e
contracts – not ex change-traded ones, for w hich no cou nterparty
charge is requ ired. Equ ation (10.5) show s that a bank w ill obtain
capital relief for any of its deriv ativ es trades that are collateralized by
the cou nterparty .
Corporate and retail lending

The area of corporate and retail lending saw som e of the biggest
im pacts of Basel II. This is im portant for ALM practitioners to be
aw are of becau se corporate lending is, in m any cases, the largest
proportion of a bank ’s balance sheet. Many com m entators hav e
rem ark ed that stronger rated corporates w ill seek greater dis-
interm ediation, w hile bank s m ay fi nd it attractiv e to lend to
u nrated or low -rated corporates rather than m iddle-rated corporates.
As noted elsew here, althou gh a fu ll asses sm ent shou ld w ait u ntil
at least a y ear after im plem entation, w e present here som e basic
considerations for the ALM strategist.
C orporate assets
The sim ple 100% risk w eight for corporate lending that applied
u nder Basel I has been discarded. In its place is the ratings-based
m ethodology for the standardized approach show n in Table 10.5.
Under the fou ndation IRB approach the capital charge redu ces for
higher rated corporates, so that AA-rated com panies – prev iou sly
rated 100% u nder Basel I – are now arou nd 15% . The class of assets
term ed ‘sm all- and m ediu m -sized enterprises ’ (SMEs) also gained
u nder Basel II w hen com pared w ith non-SME corporates; u nder
the IRB approach it is ex pected that the w eighting w ill be approx i-
m ately 20% low er for sm all SMEs. 16
Retail asset risk w eighting u nder Basel II w as 75% in the
standardized approach, com pared w ith 100% u nder Basel I. Residen-
tial m ortgage risk w eighting w ill decrease from 50% to 35% ; u nder
the IRB m ethod they are ex pected to fall from this to arou nd 15% .
An SME is defi ned for Basel II pu rposes as a corporate w ith annu al sales of
EUR50 m illion or less.
Table 10.5 Basel II standardized approach:

corporate risk w eights
Rating Risk w eight

(% )
AAA to AA 20
A to A 50
BBB to BB 100
Below BB 150
Unrated 100
Source: BIS.
Thu s, bank s w ith large pools of residential m ortgages gained in

capital charge term s com pared w ith non-m ortgage bank s.
C orporate assets – the standardized approach

Under the blank et 100% risk w eighting of Basel I, bank s had a greater
incentiv e, som ew hat perv ersely , to lend to low er rated corporates
becau se this resu lted in higher retu rn on capital. This anom aly is
better addressed u nder Basel II. In the standardized approach the
obligor’s form al credit rating determ ines capital charge risk w eight-
ing. Broadly , the only u nchanged case is corporates rated from BBB
to BB w hich rem ain at 100% . All other corporates hav e changed
risk w eights. Bank s that adopt the standardized approach then hav e
little incentiv e to lend to entities in this rating category , w hereas
they hav e an incentiv e to lend to u ndated corporates com pared w ith
those rated below BB . An u nrated corporate w ill hav e no incentiv e
to apply for a credit rating u nless this is lik ely to be better than BBB ,
as the lending rate m ay be prohibitiv e.
C orporate assets – the IRB approaches

Bank s im plem enting the fou ndation IRB m ethodology are allow ed to
u se their internal credit risk m odels to estim ate the PD v alu es for
each obligor; 17 the v alu es for the LGD, EAD and M param eters are
prescribed by the BIS. Under the adv anced IRB a bank m ay u se its
ow n estim ates of all fou r param eters.
There is a BIS-im posed m inim u m PD of 0.03% .

Illustration using a hypothetical example

We u se a sim ple ex am ple to illu strate the im pact of Basel II. Consider
a bank lending to tw o entities:
a u tility com pany rated AA;
an indu strial com pany rated BB .
Under Basel I a loan of USD10 m illion to each com pany w ou ld each
attract a m inim u m capital charge of USD800,000.00. Under the
standardized approach of Basel II the charge for the loan to the
u tility com pany w ou ld be USD160,000, w hile the requ irem ent for
the indu strial com pany w ou ld be u nchanged at USD800,000.
Under the fou ndation approach, the bank w ou ld u s e its PD v alu e to
calcu late the risk w eighting; assu m ing the calcu lation cam e to 15%
for the u tility com pany the capital charge w ou ld now be
USD120,000. Again, w e assu m e the risk w eight for the indu strial
com pany w as w ork ed ou t as 95% ; this leads to a capital charge of
USD760,000. Risk w eight v alu es u nder the adv anced IRB w ou ld u se
the bank ’s internal data for all calcu lation param eters, bu t m ay w ell
be higher for the indu strial com pany , m ak ing this asset an ev en m ore
ex pensiv e one w hen com pared w ith the Basel I regim e.
Basel III
In Septem ber 2010 the Basel Com m ittee for Bank ing Su perv ision
(BCBS), w hich com prises the regu lators and central bank ers of 27
cou ntries, released details of the new bank ing regu latory capital
ru les , w hich w ere term ed Basel III. The ru les requ ire bank s to
hold a higher am ou nt of core Tier 1 capital than w as requ ired
u nder the Basel I and II regim es.
The m ain prov isions of Basel III are as follow s:
the m inim u m lev el of core Tier 1 capital to be 4.5% of risk -
w eighted assets – this com pares w ith the 2% lev el requ ired
u nder the Basel II accord;
a ‘capital conserv ation’ bu ffer of 2.5% w ill also be requ ired, as
protection against periods of econom ic and fi nancial stres s;
there w ill be a Tier 1 ‘lev erage ratio’ of 3% .
Althou gh this additional reserv e is not com pu ls ory , a bank that does
not pu t it in place w ill be restricted from pay ing div idends to share-
holders; therefore, for practical pu rposes the m inim u m Tier 1 capital

ratio is actu ally 7% .
In addition, a ‘cou ntercy clical’ capital bu ffer of u p to 2.5% w ill be
allow able, w ith national regu lators hav ing the au thority to im pos e
this requ irem ent w hen they deem it necessary , as a response to
ov erheating m ark ets.
The defi nition of core Tier 1 capital is also being sim plifi ed u nder
Basel III; going forw ard, it w ill com prise only equ ity , retained re-
serv es and u ndated preference shares . Tier 2 has also been sim plifi ed
and w ill only com prise preferred shares , hy brid su bordinated debt
and long-term su bordinated debt w ithou t incentiv e to redeem (su ch
as step-u p cou pons).
The tim eline for im plem entation is Janu ary 2015, w ith the capital
conserv ation bu ffer not requ ired u ntil Janu ary 2019.
As of the tim e of w riting, Basel III had not m ade any m odifi cations
to the process of assigning risk w eightings to assets. This rem ains
identical to the m ethodology im plem ented u nder Basel II.
Initial impact
The Basel III ru les are possibly m ore onerou s for bank s than a fi rst
reading m ight su ggest, particu larly w hen the Tier 1 capital ratio is
tak en together w ith the proposals for a lev erage ratio and liqu idity
bu ffers. How ev er, althou gh bank s w ill need to hold m ore high-
qu ality capital, they hav e been allow ed a long-transition phase to
im plem ent the new requ irem ents . They w ill need to hold com m on
equ ity to the v alu e of 4.5% of their assets by the start of 2015, u p
from the cu rrent 2% . Bey ond that, by Janu ary 2019 bank s w ill need to
hold a 2.5% capital conserv ation bu ffer of com m on equ ity . The
rationale of the bu ffer is that it is ju st that – a bu ffer that can be
ru n dow n du ring periods of m ark et stress, w ithou t hitting the reg-
u latory reserv e and thu s preserv ing the bank as a going concern. The
total requ irem ent com prises the com m on equ ity ratio of 7% stated
abov e. This is a considerable increase on the prev iou s m inim u m
of 2% .
In addition, the BCBS is introdu cing new ru les from 2012 that
dem and a m ore onerou s capital regim e for trading activ ities and
secu ritized assets held on the trading book . This is ex pected to be
three tim es the lev el requ ired against bank ing book assets. Large
sy stem ically im portant bank s w ill, at a point in the fu tu re, face a

capital su rcharge on top of the standard requ irem ents .
A m ore problem atic area of the new ru les is the cou ntercy clical
bu ffer. If regu lators believ e that bank s are in the m ids t of a credit
bu bble they m ay lev y a cou ntercy clical bu ffer of u p to 2.5% of assets,
w hich w ill be m ade u p of com m on stock or other equ ally loss-
absorbing instru m ents .
The Tier 1 lev erage ratio of 3% w ill lim it bank s to lending 33 tim es
their capital, a signifi cantly low er v alu e than that observ ed by som e
bank s leading u p to the fi nancial crash. This represents a cap on bank
risk irrespectiv e of the im pact from higher capital nu m bers.
Althou gh this lim it is not du e to be introdu ced u ntil 2018, bank s
w ill need to disclose the lev el to the m ark et from 2015 onw ards .
BIBLIOGRAPHY
BIS (1988) International C onvergence of C apital Measurement and C apital
Standards, Basel Com m ittee on Bank ing Regu lations and Su perv isory
Practice, Ju ly .
Fabozzi, F. and Chou dhry , M. (Eds) (2004) The H andbook of European
Fixed Income Securities, John Wiley & Sons, Inc.
FSA (2008) C onsultation Paper 189.
Gu p, B. (2004) The N ew Basel C apital Accord, Thom son Corporation, New
York .
By Moorad Choudhry
Appendix
A
SUMMARY OF BANK
PRODUCT LINE
308 APPENDIX A
A s part of the introdu ction to bank ing w e prov ide a su m m ary of

the produ ct line offered by bank s. Not all bank s offer all these
produ cts, bu t these instru m ents are av ailable in v irtu ally ev ery
bank ing m ark et. More detailed inform ation is av ailable in the
au thor’s book s The Money Market H andbook, Fixed Income
Markets and Bank Asset and Liability Management, all pu blis hed
by John Wiley & Sons (Asia) Pte Ltd.
Interest-bearing and non-interest-bearing current accounts

Thes e are also k now n as chequ e accou nts or (in the USA) check ing
accou nts; they are the sim plest form of short-term deposit or inv est-
m ent instru m ent. Cu stom er fu nds m ay be w ithdraw n instantly on
dem and and bank s generally pay interest on su rplu s balances,
althou gh not in all cases. Cu rrent accou nts are a cheap sou rce of
fu nding for bank s, as w ell as a stable one, bu t the fu nds are less
v alu able from a liqu idity m etrics point of v iew becau se their
balances are instant access.
Demand deposits
Also referred to as sight deposits, they are sim ilar to chequ e accou nts
bu t are alw ay s interest bearing. The fu nds are av ailable on dem and,
bu t cannot be u sed for chequ es or other sim ilar pay m ents .
Time deposits
Tim e or term deposits are interest-bearing deposit accou nts of fi x ed
m atu rity . They are u su ally offered w ith a range of m atu rities ranging
from 1 m onth to 5 y ears, w ith longer dated deposits attracting higher
interest. This refl ects the positiv e y ield cu rv e, w hich indicates the
fu nding v alu e to the bank of longer term liabilities. Most tim e
deposits pay a fi x ed rate of interest, pay able on m atu rity . Accou nts
of longer than 1-y ear m atu rity often capitalize interest on an annu al
basis.
Government bonds
The secondary m ark et in gov ernm ent bonds is prov ided by bank s
that choose to be m ark et-m ak ers or prim ary dealers. Sov ereign debt
is essentially a plain v anilla m ark et, w ith the v ast m ajority of bonds
APPENDIX A 309
being fi x ed cou pon and fi x ed m atu rity . Gov ernm ents also issu e
index -link ed bonds w hich offer retu rn link ed to the rate of infl ation.
Floating rate notes

Floating rate notes (FRNs) are bonds that hav e v ariable rates of
interest; the cou pon rate is link ed to a specifi ed index and
changes periodically as the index changes. An FRN is u su ally
issu ed w ith a cou pon that pay s a fi x ed spread ov er a reference
index (e.g., the cou pon m ay be 50 bp ov er the 6-m onth Libor rate).
Since the v alu e for the reference benchm ark index is not k now n, it is
not possible to calcu late the redem ption y ield for an FRN. Additional
featu res hav e been added to FRNs, inclu ding fl oors (the cou pon
cannot fall below a specifi ed m inim u m rate), caps (the cou pon
cannot rise abov e a m ax im u m rate) and callability.
Generally , the reference interest rate for FRNs is the London
interbank offered rate or Libor. An FRN w ill pay interest at Libor
plu s a qu oted m argin (or spread). The interest rate is fi x ed for a
3-m onth or 6-m onth period and is reset in line w ith the Libor
fi x ing at the end of the interest period. Hence, at the cou pon reset
date for a sterling FRN pay ing 6-m onth Libor 0.50% , if the Libor fi x
is 7.6875% , then the FRN w ill pay a cou pon of 8.1875% . Interest w ill
therefore accru e at a daily rate of £0.0224315.
On the cou pon reset date an FRN w ill be priced precisely at par.
Betw een reset dates it w ill trade v ery close to par becau se of the w ay
in w hich the cou pon is reset. If m ark et rates rise betw een reset dates
an FRN w ill trade slightly below par; sim ilarly , if rates fall the paper
w ill trade slightly abov e. This m ak es FRNs v ery sim ilar in behav iou r
to m oney m ark et instru m ents traded on a y ield basis , althou gh of
cou rse FRNs hav e m u ch longer m atu rities. Inv estors can opt to v iew
FRNs as essentially m oney m ark et instru m ents or as alternativ es to
conv entional bonds . For this reason w e can u se tw o approaches w hen
analy sing FRNs. The fi rst approach is k now n as the margin method.
This calcu lates the difference betw een the retu rn on an FRN and that
on an equ iv alent m oney m ark et secu rity . There are tw o v ariations
on this: sim ple m argin and discou nted m argin.
Letter of credit
A letter of credit (LoC) is a standard v anilla produ ct av ailable from a
com m ercial bank . It is an instru m ent that gu arantees that a bu y er’s
310 APPENDIX A
pay m ent to a seller w ill be receiv ed at the right tim e and for the
specifi c am ou nt. The bu y er is the cu stom er of the bank . If the bu y er
is u nable to m ak e pay m ent on the du e date, the bank w ill cov er the
fu ll am ou nt of the pu rchase. The bank therefore tak es on the credit
risk of the bu y er w hen it w rites an LoC on the bu y er’s behalf. The
bu y er therefore pay s a fee for the LoC that refl ects its credit standing.
LoCs are u sed in dom estic and international trade transactions.
Cros s-border trade transactions inv olv e both parties in issu es su ch
as distance, different legal ju risdictions and lack of any av ailable du e
diligence on the cou nterparties. An LoC is a v alu able tool that eases
the process for the bu y ing and selling parties. The bank also acts on
behalf of the bu y er (the pu rchaser of the LoC) becau se it w ou ld only
m ak e pay m ent w hen it k now s that the goods hav e been shipped. For
the seller, an LoC su bstitu tes the credit of the bu y er for that of the
bank , w hich is an easier risk ex posu re for the seller to tak e on.
There are essentially tw o ty pes of LoC: com m ercial and standby .
A com m ercial LoC is the prim ary pay m ent m echanism for a
transaction, w hile a standby LoC is a secondary pay m ent
m echanism .
C ommercial letter of credit

A com m ercial LoC is a contract betw een a bank , k now n as the
issu ing bank , on behalf of one of its cu stom ers, au thorizing
another bank , k now n as the adv ising or confi rm ing bank , to m ak e
pay m ent to the benefi ciary . The issu ing bank m ak es a com m itm ent
to gu arantee draw ings m ade u nder the credit. The benefi ciary is
norm ally the prov ider of goods and/or serv ices. An adv ising bank ,
u su ally a foreign correspondent bank of the issu ing bank , w ill adv ise
the benefi ciary bu t otherw ise has no other obligation u nder the LoC.
An LoC is generally negotiable; this m eans that the issu ing bank is
obliged to pay the benefi ciary bu t – shou ld the issu ing bank so
requ est – any bank nom inated by the benefi ciary cou ld m ak e the
pay m ents . To be negotiable, the LoC featu res an u nconditional
prom ise to pay on dem and at a specifi ed tim e.
Standby letter of credit

A standby LoC is a contract issu ed by a bank on behalf of a cu stom er
to prov ide assu rances of its ability to perform u nder the term s of a
contract betw een it and the benefi ciary . In other w ords, a standby
LoC is m ore of a gu arantee, as both parties to the transaction do not
APPENDIX A 311
ex pect the LoC w ill be draw n on. It essentially prov ides com fort to
the benefi ciary , as it enhances the creditw orthines s of its cu stom er.
Structured deposits
A stru ctu red deposit is a deposit w hose pay off or retu rn profi le is
stru ctu red to m atch a specifi c cu stom er requ irem ent. The stru ctu r-
ing resu lts from the u se of an em bedded deriv ativ e in the produ ct,
w hich link s the deposit to changes in interest rates, FX rates or other
m ark et rates. There is a w ide range of different produ cts av ailable
that fall in the class of ‘stru ctu red deposit’. An ex am ple is the
follow ing: a cu stom er places fu nds on deposit at a specifi c interest
rate and fi x ed term . Under the agreem ent, if the central bank base
interest rate rem ains betw een 4% and 5% , then retu rn is enhanced
by 100 bp. If the rate m ov es below 4% or abov e 5% , then the deposit
forfeits all interest for the rem aining term of its life. This is an
ex am ple of a ‘collared range accru al’ deposit.
Liquidity facilities
Liqu idity facility is the generic term for a standing loan agreem ent,
against w hich a borrow er can draw dow n fu nds at any tim e u p to the
m ax im u m v alu e of the line. The borrow er pay s a fee, called the
standing fee, ev en if the line is not u sed and then pay s the agreed
rate of interest on any fu nds that it does draw .
We distingu ish betw een the follow ing:
Back-up facility. A facility that is not u sed in the norm al cou rse
of bu sines s. It is generally draw n dow n if the borrow er is ex peri-
encing som e diffi cu lty in obtaining fu nding from its u su al
sou rces .
Revolving credit facility (RC F). A com m itm ent from a bank to
lend on a rev olv ing basis u nder pre-specifi ed term s. Under an
RCF there is u su ally a regu lar draw dow n and repay m ent of fu nds
du ring the life of the facility .
Term loan. This is distinct from liqu idity lines in that it is a non-
rev olv ing facility and w ill be draw n dow n at ex ecu tion. It has a
fi x ed repay m ent date, althou gh this m ay be on an am ortized
basis.
Liqu idity facilities requ ire fu ll regu latory capital back ing, as the
capital treatm ent is to assu m e that they are being u sed at all tim es.
312 APPENDIX A
Syndicated loans1
To raise debt capital, com panies m ay issu e bonds or loans (as w ell as
other debt-lik e instru m ents ), both of w hich are associated w ith a
certain seniority or rank ing. In a liqu idation or w inding u p, the
borrow er’s rem aining assets are distribu ted according to a priority
w aterfall: debt obligations w ith the highest seniority are repaid fi rst;
only if assets rem ain thereafter are obligations w ith low er seniorities
repaid. Fu rther, debt instru m ents m ay be secu red or u ns ecu red: if
certain of the borrow er’s assets are ring-fenced to serv e as collateral
for the lenders u nder a particu lar obligation only , this obligation is
deem ed to be ‘secu red’. Together, seniority and collateral determ ine
the priority of an obligation. As illu strated in Table A.1, bonds and
loans issu ed by inv estm ent-grade com panies, as w ell as bonds
issu ed by su b-inv estm ent-grade com panies, called ‘high-y ield
bonds ’, are ty pically senior u nsecu red. How ev er, loans issu ed
by su b-inv estm ent-grade com panies are ty pically senior secu red.
Often, these are called ‘lev eraged loans’ or ‘sy ndicated secu red
loans’. The m ark et often u ses both term s interchangeably .
Table A.1 Ty pical priorities of corporate bonds and loans of

inv estm ent grade and su b-inv estm ent-grade borrow ers
Investm ent-grade borrow er Sub-investm ent-grade borrow er
Bonds Senior u nsecu red Senior u nsecu red

(high-y ield bonds)
Loans Senior u nsecu red Senior secu red
(lev eraged loans/sy ndicated
secu red loans)
Source: Chou dhry (2010).
The defi nition of ‘lev eraged loan’ is not u niv ers al, how ev er. Variou s
m ark et participants defi ne a lev eraged loan to be a loan w ith a su b-
inv estm ent-grade rating, w hile other u sers v iew it as one w ith a
certain spread ov er Libor (say 100 bp or m ore) and som etim es a
certain debt/EBITDA ratio of the borrow er. S&P, for instance,
1
This section is an ex tract from chapter 11 of the au thor’s book Structured
C redit Products: C redit D erivatives and Synthetic Securitisation, 2nd
edition, John Wiley & Sons (Asia), 2010. This chapter from the au thor’s
book w as co-w ritten w ith Tim o Schlafer and Marliese Uhrig-Hom bu rg.
APPENDIX A 313
calls a loan ‘lev eraged’ if it is rated su b-inv estm ent grade or if it is

rated inv estm ent grade bu t pay s interest of at least Libor 125 bp.
Bloom berg u s es a hu rdle rate of Libor 250 bp. Essentially , the
m ark et refers to lev eraged loans and high-y ield bonds as ‘high-
y ield debt’.
Lev eraged loans m ay be arranged either betw een a borrow er and

a single lending bank , or, m ore com m only , betw een a borrow er
and a sy ndicate of lending bank s. In the latter case, one (or m ore)
of the lending bank s acts as lead arranger. Before any other lending
bank s are inv olv ed, the lead arranger condu cts detailed du e diligence
on the borrow er. Also, the lead arranger and borrow er agree on the
basic transaction term s, su ch as size of the loan, interest rate, fees,
loan stru ctu re, cov enants and ty pe of sy ndication. Thes e term s are
docu m ented in a ‘loan agreem ent’. Based on the inform ation
receiv ed in the du e diligence process, the lead arranger prepares
an inform ation m em orandu m , also called the ‘bank book ’ w hich
is u sed to m ark et the transaction to other potential lending bank s
or institu tional inv estors. Together, the lead arranger and the other
lenders constitu te the prim ary m ark et. If the transaction is an
‘u nderw ritten sy ndication’, the lead arranger gu arantees the
borrow er that the entire am ou nt of the loan w ill be placed at a
pre-defi ned price. If the loan is u ndersu bscribed at that price, the
lead arranger is forced to absorb the difference. If the transaction is a
‘best efforts sy ndication’, the lead arranger tries to place the loan at
the pre-defi ned term s bu t w ill, if inv estor dem and is insu ffi cient,
adju st these term s to achiev e fu ll placem ent.
Lev eraged loans are u su ally secu red by particu lar assets of the
borrow er. Thes e assets are listed in the loan agreem ent and m ay
com prise all tangible and intangible assets of the borrow er. This
m eans that, in the ev ent of defau lt, lenders can tak e possess ion of
these assets, liqu idate them and u se the proceeds to satisfy their
claim s in the order of priority stipu lated in the loan agreem ent and
the related inter-creditor agreem ent. This happens before the claim s
of any u nsecu red lenders are satisfi ed.
Lev eraged loans ty pically consist of a rev olv ing credit facility (or
‘rev olv er’) and ‘term loans’ . Term loans are u su ally tranched into
an am ortizing term loan (term loan A), prov ided by sy ndicate bank s,
and institu tional tranches (term loans B, C and D), prov ided by
institu tional inv estors. In the US m ark et, am ortizing term loans
hav e becom e increasingly rare as institu tional inv estors are now
the prim ary bu y ers of lev eraged loans. Term loan D m ay represent
314 APPENDIX A
a fu rther su bdiv ision, called ‘second-lien tranche’ , w hich is

su bordinate to term loans A, B and C (called ‘fi rst-lien tranches’),
bu t rank s senior to all other debt of the borrow er. Historically , this
stru ctu re has resu lted in signifi cantly higher recov ery rates of fi rst-
lien tranches com pared w ith second-lien tranches .
Term loan A is u su ally repaid on schedu led repay m ent dates du ring
its life, w hereas term loans B, C and D are m ostly su bject to bu llet
repay m ent (i.e., a one-off repay m ent on the m atu rity date). Once
repaid, term loans cannot be re-borrow ed. This is the principal
difference from the rev olv ing credit facility , u su ally prov ided by
sy ndicate lenders , w hich allow s the borrow er to borrow , repay ,
and re-borrow fu nds du ring the life of the loan in accordance w ith
predeterm ined conditions. In addition to interest on borrow ed fu nds,
borrow ers are charged a com m itm ent fee on u nu s ed fu nds. Rev olv ers
are often u sed to fu nd w ork ing capital and capital ex penditu re
requ irem ents that can fl u ctu ate signifi cantly ov er tim e. Table A.2
su m m arizes this discu ssion.
Table A.2 Ty pical stru ctu re of lev eraged loans

Lien Lender Repay m ent
Rev olv ing credit facility Discretionary

Bank s
A Am ortizing
First lien
Term loans B
C Institu tional Bu llet
D Second lien inv estors
Source: Chou dhry (2007).
Lev eraged loans pay fl oating rate cou pons. Thes e are com posed of
Libor (or another inter-bank rate, depending on the loan’s cu rrency ),
plu s a certain spread (i.e., risk prem iu m ); ty pically , they are pay able
qu arterly . Floating rate cou pons prov ide an effectiv e hedge against
interest rate risk : if interest rates rise, so does the cou pon and v ice
v ersa. Consequ ently , fl oating rate cou pons are particu larly popu lar
in tim es of rising interest rates. Often, the spread of lev eraged loans is
not fu lly fi x ed bu t m ov es according to a pricing grid pre-defi ned in
the loan agreem ent: if the borrow er’s credit condition im prov es (e.g.,
indicated by a decline in fi nancial lev erage and/or a rating u pgrade),
the spread decreases and v ice v ersa.
Lev eraged loans com m only m atu re betw een 7 to 10 y ears after
issu ance. The effectiv e life of lev eraged loans, how ev er, tends to
APPENDIX A 315
be signifi cantly shorter as the borrow er is ty pically allow ed to prepay

or ‘call’ the loan at any tim e at no prem iu m or a lim ited prem iu m .
Prepay m ent is generally seen as a negativ e by lenders. This is
becau se borrow ers tend to prepay w hen their refi nancing costs de-
crease; for instance, w hen they are u pgraded to inv estm ent grade or
acqu ired by an inv estm ent-grade-rated com pany or w hen interest
rates decrease. For lenders , this m eans that they bear all the dow n-
side (i.e., rising interest rates or a deterioration in the borrow er’s
credit condition) bu t retain a lim ited u pside. As m entioned, fl oating
rate cou pons m itigate lenders ’ risk associated w ith rising interest
rates. To som e ex tent, pricing grids can do the sam e for the risk
associated w ith a deterioration in the borrow er’s credit condition.
REFERENCE
Chou dhry , M. (2007). Bank Asset and Liability Management, Singapore:
John Wiley & Sons.
By Moorad Choudhry
Appendix
B
FINANCIAL
MARKETS
ARITHMETIC
318 APPENDIX B
Sim ple interest

A loan that has one interest pay m ent on m atu rity is accru ing sim ple
interest. On short-term instru m ents there is u su ally only the one
interest pay m ent on m atu rity , hence sim ple interest is receiv ed
w hen the instru m ent ex pires . The term inal v alu e of an inv estm ent
w ith sim ple interest is giv en by :
FV PV 1 r B1
w here
FV Term inal v alu e or fu tu re v alu e;
PV Initial inv estm ent or present v alu e;
r Interest rate.
So, for ex am ple, if PV is £100, r is 5% and the inv estm ent is 1 y ear.
Then
FV £100 1 r £105
The m ark et conv ention is to qu ote interest rates as annualized
interest rates, w hich is the interest that is earned if the inv estm ent
term is 1 y ear. Consider a 3-m onth deposit of £100 in a bank , placed
at a rate of interest of 6% . In su ch an ex am ple the bank deposit w ill
earn 6% interest for a period of 90 day s. As the annu al interest gain
w ou ld be £6, the inv estor w ill ex pect to receiv e a proportion of this:
90
£6 00
365
So, the inv estor w ill receiv e £1.479 interest at the end of the term .
The total proceeds after the 3 m onths is therefore £100 plu s £1.479.
If w e w ish to calcu late the term inal v alu e of a short-term inv estm ent
that is accru ing sim ple interest w e u se the follow ing ex pression:
Day s
FV PV 1 r B2
Year
Day s
The fraction refers to the nu m erator, w hich is the nu m ber of
Year
day s the inv estm ent ru ns, div ided by the denom inator, w hich is the
nu m ber of day s in the y ear. In sterling m ark ets the nu m ber of day s in
a y ear is tak en to be 365; how ev er, certain other m ark ets (inclu ding
eu ro cu rrency m ark ets) hav e a 360-day y ear conv ention. For this
reason w e sim ply qu ote the ex pression as ‘day s’ div ided by ‘y ear’
to allow for either conv ention.
APPENDIX B 319
Com pound interest

Let u s now consider an inv estm ent of £100 m ade for 3 y ears, again at
a rate of 6% , bu t this tim e fi x ed for 3 y ears. At the end of the fi rst y ear
the inv estor w ill be credited w ith interest of £6. Therefore, for the
second y ear the interest rate of 6% w ill be accru ing on a principal
su m of £106, w hich m eans that at the end of Year 2 the interest
credited w ill be £6.36. This illu strates how compounding w ork s,
w hich is the principle of earning interest on interest. What w ill
the term inal v alu e of ou r £100 3-y ear inv estm ent be?
In com pou nding w e are seek ing to fi nd a future value giv en a present
value, a time period and an interest rate. If £100 is inv ested today (at
tim e t0 ) at 6% , then 1 y ear later (t1 ) the inv estor w ill hav e
£100 1 0 06 £106. In ou r ex am ple the capital is left in for
another 2 y ears, so at the end of Year 2 (t2 ) w e w ill hav e:
2
£100 1 0 06 1 0 06 £100 1 0 06
2
£100 1 06
£112 36
The ou tcom e of the process of com pou nding is the future value of
the initial am ou nt. We don’t hav e to calcu late the term inal v alu e
long hand as w e can u se:
n
FV PV 1 r B3
w here
r Periodic rate of interest (ex pressed as a decim al);
n Nu m ber of periods for w hich the su m is inv ested.
In ou r ex am ple, the initial £100 inv estm ent after 3 y ears becom es
£100 1 0 06 3 w hich is equ al to £119.10.
When w e com pou nd interest w e hav e to assu m e that the
reinv es tm ent of interest pay m ents du ring the inv estm ent term is
at the sam e rate as the fi rst y ear’s interest. That is w hy w e stated that
the 6% rate in ou r ex am ple w as fixed for 3 y ears. How ev er, w e can
see that com pou nding increases ou r retu rns com pared w ith inv est-
m ents that accru e only on a sim ple interest basis. If w e had inv ested
£100 for 3 y ears fi x ed at a rate of 6% bu t pay ing on a sim ple interest
basis ou r term inal v alu e w ou ld be £118, w hich is £1.10 less than ou r
term inal v alu e u sing a com pou nd interest basis .
320 APPENDIX B
Com pounding m ore than once a y ear

Now let u s consider a deposit of £100 for 1 y ear, again at ou r rate of
6% bu t w ith qu arterly interest pay m ents. Su ch a deposit w ou ld
accru e interest of £6 in the norm al w ay , bu t £1.50 w ou ld be credited
to the accou nt ev ery qu arter, and this w ou ld then benefi t from
com pou nding. Again assu m ing that w e can reinv es t at the sam e
rate of 6% , the total retu rn at the end of the y ear w ill be:
100 1 0 015 1 0 015 1 0 015 1 0 015
4
100 1 0 015
w hich giv es u s 100 1 06136, a term inal v alu e of £106.136. This
is som e 13 pence m ore than the term inal v alu e u sing annu al
com pou nded interest.
In general, if com pou nding tak es place m tim es per y ear, then at the
end of n y ears mn interest pay m ents w ill hav e been m ade and the
fu tu re v alu e of the principal is giv en by :
r mn
FV PV 1 B4
m
As w e show ed in ou r ex am ple, the effect of m ore frequ ent
com pou nding is to increase the v alu e of total retu rn w hen com pared
w ith annu al com pou nding. The effect of m ore frequ ent com pou nd-
ing is show n below , w here w e consider annu alized interest rate
factors, for an annu alized rate of 5% .
Com pounding frequency Interest rate factor
Annu al (1 + r)= 1.050000

r 2
Sem i-annu al 1 1.050625
2
r 4
Qu arterly 1 1.050945
4
r 12
Monthly 1 1.051162
12
r 365
Daily 1 1.051267
365
This show s u s that the m ore frequ ent the com pou nding the higher
the interest rate factor. The last case also illu strates how a lim it
APPENDIX B 321
occu rs w hen interest is com pou nded continu ou sly . Equ ation (B.4)
can be rew ritten as:
r m r rn 1 m r rn
FV PV 1 PV 1
m m r
1 n rn
PV 1 B5
n
w here n m r. As com pou nding becom es continu ou s and m and

hence n approach infi nity , equ ation (B.5) approaches a v alu e k now n
as e, w hich is show n by :
1 n
e lim 1 2 718281
n n
If w e su bstitu te this into (B.5) w e get:
FV PVe rn B6
w here w e hav e continu ou s com pou nding. In equ ation (B.6) e rn is

k now n as the exponential function of rn; it tells u s the continu ou s ly
com pou nded interest rate factor. If r 5% and n 1 y ear then:
0 05
er 2 718281 1 051271
This is the lim it reached w ith continu ou s com pou nding. To

illu strate continu ou s com pou nding from ou r initial ex am ple, the
fu tu re v alu e of £100 at the end of 3 y ears – w hen the interest rate
is 6% – can be giv en by :
0 06 3
FV 100e £119 72
Effective interest rates

The interest rate qu oted on a deposit or loan is u su ally the flat rate.
How ev er, w e are often requ ired to com pare tw o interest rates w hich
apply for a sim ilar inv estm ent period bu t hav e different interest
pay m ent frequ encies – for ex am ple, a 2-y ear interest rate w ith inter-
est paid qu arterly com pared w ith a 2-y ear rate w ith sem i-annu al
interest pay m ents. This is norm ally done by com paring equ iv alent
annualized rates. The annu alized rate is the interest rate w ith
annu al com pou nding that resu lts in the sam e retu rn at the end of
the period as the rate w e are com paring.
322 APPENDIX B
The concept of the effectiv e interest rate allow s u s to state that:

r n
PV 1 PV 1 AER B7
n
w here AER is the equ iv alent annu al rate. Therefore, if r is the
interest rate qu oted that pay s n interest pay m ents per y ear, AER
is giv en by :
r n
AER 1 1 B8
n
The equ iv alent annu al interest rate AER is k now n as the effective
interest rate. We hav e already referred to the qu oted interest rate as
the ‘nom inal’ interest rate. We can rearrange equ ation (B.8) to giv e u s
equ ation (B.9) w hich allow s u s to calcu late nom inal rates:
1 n
r 1 AER 1 n B9
We can see then that the effectiv e rate w ill be greater than the fl at
rate if com pou nding tak es place m ore than once a y ear. The effectiv e
rate is som etim es referred to as the annualized percentage rate or
APR.
Interest rate conventions

The conv ention in both w holesale or personal (retail) m ark ets is to
qu ote an annu al interest rate. A lender w ho w ishes to earn interest at
the rate qu oted has to place her fu nds on deposit for 1 y ear. Annu al
rates are qu oted irrespectiv e of the m atu rity of a deposit, from ov er-
night to 10 y ears or longer. For ex am ple, if one opens a bank accou nt
that pay s interest at a rate of 3.5% bu t then closes it after 6 m onths,
the actu al interest earned w ill be equ al to 1.75% of the su m depos-
ited. The actu al retu rn on a 3-y ear bu ilding society bond (fi x ed
deposit) that pay s 6.75% fi x ed for 3 y ears is 21.65% after 3 y ears.
The qu oted rate is the annu al 1-y ear equ iv alent. An ov ernight
deposit in the w holesale or inter-bank m ark et is still qu oted as an
annu al rate, ev en thou gh interest is earned for only one day .
The conv ention of qu oting annu alized rates is to allow deposits
and loans of different m atu rities and different instru m ents to be
com pared on the basis of the interest rate applicable. We m u st
also be carefu l w hen com paring interest rates for produ cts that
hav e different pay m ent frequ encies. As w e hav e seen from the
APPENDIX B 323
foregoing paragraphs the actu al interest earned w ill be greater for a

deposit earning 6% on a sem i-annu al basis com pared w ith 6% on an
annu al basis . The conv ention in the m oney m ark ets is to qu ote the
equ iv alent interest rate applicable w hen tak ing into accou nt an
instru m ent’ s pay m ent frequ ency .
Discount factors
The calcu lation of present v alu es from fu tu re v alu es is also k now n as
discounting. The principles of present and fu tu re v alu es dem onstrate
the concept of the time value of m oney w hich is that in an env iron-
m ent of positiv e interest rates a su m of m oney has greater v alu e
today than it does at som e point in the fu tu re becau se w e are able
to inv est the su m today and earn interest. We w ill only consider a
su m in the fu tu re com pared w ith a su m today if w e are com pensated
by being paid interest at a su ffi cient rate. Discou nting fu tu re
v alu es allow s u s to com pare the v alu e of a fu tu re su m w ith a
present su m .
The rate of interest r, k now n as the discount rate, is the rate w e u se

to discount a k now n fu tu re v alu e in order to calcu late a present
v alu e. We can rearrange equ ation (B.1) to giv e:
n
PV FV 1 r
The term 1 r n
is k now n as the n-y ear discou nt factor:
n
dfn 1 r B 10
w here dfn is the n-y ear discou nt factor.
The 3-y ear discou nt factor w hen the discou nt rate is 9% is:
3
df3 1 0 09 0 77218
We can calcu late discou nt factors for all possible interest rates
and tim e periods to giv e u s a discount function. Fortu nately , w e
don’ t need to calcu late discou nt factors ou rselv es as this has been
done for u s (discou nt tables for a range of rates are prov ided in Table
B.1).
324
Table B.1 Discou nt Factor Table

Discount rate (% )
Years 1 2 3 4 5 6 7 8 9 10 12 15 20
0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1 0.12 0.15 0.2
1 0.990099 0.980392 0.970874 0.961538 0.952381 0.943396 0.934579 0.925926 0.917431 0.909091 0.892857 0.869565 0.833333
2 0.980296 0.961169 0.942596 0.924556 0.907029 0.889996 0.873439 0.857339 0.841680 0.826446 0.797194 0.756144 0.694444
3 0.970590 0.942322 0.915142 0.888996 0.863838 0.839619 0.816298 0.793832 0.772183 0.751315 0.711780 0.657516 0.578704
4 0.960980 0.923845 0.888487 0.854804 0.822702 0.792094 0.762895 0.735030 0.708425 0.683013 0.635518 0.571753 0.482253
5 0.951466 0.905731 0.862609 0.821927 0.783526 0.747258 0.712986 0.680583 0.649931 0.620921 0.567427 0.497177 0.401878
6 0.942045 0.887971 0.837484 0.790315 0.746215 0.704961 0.666342 0.630170 0.596267 0.564474 0.506631 0.432328 0.334898
7 0.932718 0.870560 0.813092 0.759918 0.710681 0.665057 0.622750 0.583490 0.547034 0.513158 0.452349 0.375937 0.279082
8 0.923483 0.853490 0.789409 0.730690 0.676839 0.627412 0.582009 0.540269 0.501866 0.466507 0.403883 0.326902 0.232568
9 0.914340 0.836755 0.766417 0.702587 0.644609 0.591898 0.543934 0.500249 0.460428 0.424098 0.360610 0.284262 0.193807
10 0.905287 0.820348 0.744094 0.675564 0.613913 0.558395 0.508349 0.463193 0.422411 0.385543 0.321973 0.247185 0.161506
11 0.896324 0.804263 0.722421 0.649581 0.584679 0.526788 0.475093 0.428883 0.387533 0.350494 0.287476 0.214943 0.134588
12 0.887449 0.788493 0.701380 0.624597 0.556837 0.496969 0.444012 0.397114 0.355535 0.318631 0.256675 0.186907 0.112157
13 0.878663 0.773033 0.680951 0.600574 0.530321 0.468839 0.414964 0.367698 0.326179 0.289664 0.229174 0.162528 0.093464
14 0.869963 0.757875 0.661118 0.577475 0.505068 0.442301 0.387817 0.340461 0.299246 0.263331 0.204620 0.141329 0.077887
15 0.861349 0.743015 0.641862 0.555265 0.481017 0.417265 0.362446 0.315242 0.274538 0.239392 0.182696 0.122894 0.064905
APPENDIX B
16 0.852821 0.728446 0.623167 0.533908 0.458112 0.393646 0.338735 0.291890 0.251870 0.217629 0.163122 0.106865 0.054088
17 0.844377 0.714163 0.605016 0.513373 0.436297 0.371364 0.316574 0.270269 0.231073 0.197845 0.145644 0.092926 0.045073
18 0.836017 0.700159 0.587395 0.493628 0.415521 0.350344 0.295864 0.250249 0.211994 0.179859 0.130040 0.080805 0.037561
19 0.827740 0.686431 0.570286 0.474642 0.395734 0.330513 0.276508 0.231712 0.194490 0.163508 0.116107 0.070265 0.031301
20 0.819544 0.672971 0.553676 0.456387 0.376889 0.311805 0.258419 0.214548 0.178431 0.148644 0.103667 0.061100 0.026084
APPENDIX B
21 0.811430 0.659776 0.537549 0.438834 0.358942 0.294155 0.241513 0.198656 0.163698 0.135131 0.092560 0.053131 0.021737
22 0.803396 0.646839 0.521893 0.421955 0.341850 0.277505 0.225713 0.183941 0.150182 0.122846 0.082643 0.046201 0.018114
23 0.795442 0.634156 0.506692 0.405726 0.325571 0.261797 0.210947 0.170315 0.137781 0.111678 0.073788 0.040174 0.015095
24 0.787566 0.621721 0.491934 0.390121 0.310068 0.246979 0.197147 0.157699 0.126405 0.101526 0.065882 0.034934 0.012579
25 0.779768 0.609531 0.477606 0.375117 0.295303 0.232999 0.184249 0.146018 0.115968 0.092296 0.058823 0.030378 0.010483
26 0.772048 0.597579 0.463695 0.360689 0.281241 0.219810 0.172195 0.135202 0.106393 0.083905 0.052521 0.026415 0.008735
27 0.764404 0.585862 0.450189 0.346817 0.267848 0.207368 0.160930 0.125187 0.097608 0.076278 0.046894 0.022970 0.007280
28 0.756836 0.574375 0.437077 0.333477 0.255094 0.195630 0.150402 0.115914 0.089548 0.069343 0.041869 0.019974 0.006066
29 0.749342 0.563112 0.424346 0.320651 0.242946 0.184557 0.140563 0.107328 0.082155 0.063039 0.037383 0.017369 0.005055
30 0.741923 0.552071 0.411987 0.308319 0.231377 0.174110 0.131367 0.099377 0.075371 0.057309 0.033378 0.015103 0.004213
325
326 APPENDIX B
Form ula sum m ary

1
Discou nt factor w ith sim ple interest df
Day s n
1 r
Year
1 n
Discou nt factor w ith com pou nd interest dfn
1 r
Earlier w e established the continu ou sly com pou nded interest rate
factor as e rn. Therefore, u sing a continu ou sly com pou nded interest
rate w e can establish the discou nt factor to be:
1 r D ays Year
df e
1 er D ays Year 1 B 11
rn
dfn e
The continu ou sly com pou nded discou nt factor is part of the form u la
u sed in option-pricing m odels. It is possible to calcu late discou nt
factors from the prices of gov ernm ent bonds. The traditional
approach described in m ost tex tbook s requ ires that w e fi rst u se
the price of a bond that has only one rem aining cou pon, its last
one, and calcu late a discou nt factor from this bond’s price. We
then u se this discou nt factor to calcu late the discou nt factors of
bonds w ith ev er-increasing m atu rities, u ntil w e obtain the com plete
discou nt fu nction.
Present values w ith m ultiple discounting

Present v alu es for short-term inv estm ents of u nder 1-y ear m atu rity
often inv olv e a single interest pay m ent. If there is m ore than one
interest pay m ent then any discou nting needs to tak e this into
accou nt. If discou nting tak es place m tim es per y ear then w e can
u se equ ation (B.4) to deriv e the present v alu e form u la:
r mn
PV FV 1 B 12
m
For ex am ple, w hat is the present v alu e of the su m of £1,000 w hich is
to be receiv ed in 5 y ears w here the discou nt rate is 5% and there is
sem i-annu al discou nting?
APPENDIX B 327
Using equ ation (B.12) w e see that

0 05 2 5
PV 1,000 1 £781 20
2
The effect of m ore frequ ent discou nting is to low er the present v alu e.
As w ith continu ou s com pou nding, the lim iting factor is reached by
m eans of continu ou s discou nting. We can u se equ ation (B.6) to
deriv e the present v alu e form u la for continu ou s discou nting
rn
PV FVe B 13
If w e consider the sam e ex am ple as before bu t now w ith continu ou s
discou nting, w e can u se this ex pression to calcu late the present
v alu e of £1,000 to be receiv ed in 5 y ears’ tim e as:
0 05 5
PV 1,000e £778 80
MULTIPLE CASHFLOWS
Future values
Up to now w e hav e considered the fu tu re v alu es of a single cashfl ow .
Of cou rse, the sam e principles of the tim e v alu e of m oney can be
applied to a bu ndle of cashfl ow s. A series of cashfl ow s can be at
regu lar or at irregu lar interv als. If w e w is h to calcu late the total
fu tu re v alu e of a set of irregu lar pay m ents m ade in the fu tu re w e
need to calcu late each pay m ent separately and then su m all the
cashfl ow s. The form u la is represented as:
N
N n
FV Cn 1 r B 14
n 1
w here C n is the pay m ent in y ear n; and the sy m bol m eans ‘the
su m of ’. We assu m e that pay m ent is m ade and interest credited at
the end of each y ear.
It is m u ch m ore com m on to com e across a regu lar stream of fu tu re
pay m ents . Su ch a cashfl ow is k now n as an annuity. In an annu ity the
pay m ents are identical and so C n – as giv en in equ ation (B.14) –
sim ply becom es C . We can then rearrange equ ation (B.14) as:
N
N n
FV C 1 r B 15
n 1
328 APPENDIX B
This equ ation can be sim plifi ed to giv e u s: 1
1 rN 1
FV C B 16
r
This form u la can be u sed to calcu late the fu tu re v alu e of an annu ity .
For ex am ple, if w e consider an annu ity that pay s £500 each y ear for
10 y ears at a rate of 6% , its fu tu re v alu e is giv en by :
1 06 10 1
FV 500 £6,590 40
0 06
The com m on defi nition of an annu ity is a continu ou s stream of

cashfl ow s. In practice, the pension represented by an annu ity is
u su ally paid in m onthly instalm ents, sim ilar to an em ploy ed
person’s annu al salary . Certain regu lar pay m ents com pou nd
interest on a m ore frequ ent basis than annu ally , so equ ation
(B.15) needs to be adju sted slightly . If com pou nding occu rs m
tim es each y ear, then equ ation (B.15) needs to be altered to equ ation
(B.17) to allow for this:
N mN n
r
FV C 1 B 17
n 1
m
To m ak e calcu lations sim pler w e can m u ltiply both sides of equ ation
(B.17) by 1 r m and su btract the resu lt from equ ation (B.17).
Sim plify ing this w ill then resu lt in:
1 r m mN
1
FV C B 18
1 r m m 1
For ex am ple, a 10-y ear annu ity that has annu al pay m ents of £5,000,
bu t com pou nded on a qu arterly basis at a rate of 5% , w ill hav e a
1
If w e m u ltiply both sides of equ ation (B.15) by 1 r and then su btract the
resu lt from equ ation (B.15) w e obtain:
N N
N n N n 1
FV 1 r FV C 1 r 1 r
n 1 n 1
C 1 r N
1
APPENDIX B 329
fu tu re v alu e of £63,073 as:

20
1 025 1
FV 5,000 £63,073
1 025 2 1
Where there is continu ou s com pou nding, as before the lim iting
factor w ill resu lt in equ ation (B.23) becom ing:
e rN 1
FV C B 19
er 1
Equ ations (B.18) and (B.19) can be adju sted y et again to allow for
frequ ent pay m ents together w ith frequ ent com pou nding, bu t su ch a
stream of cashfl ow s is rarely encou ntered in practice. In the case of
continu ou s com pou nding of continu ou s pay m ents , the lim iting
factor ex pression is:
e rN 1
FV C B 20
r
Present values
Using sim ilar principles to those em ploy ed for calcu lating fu tu re
v alu es, w e can calcu late present v alu es for a stream of m u ltiple
cashfl ow s. The m ethod em ploy ed is slightly different according to
w hether cashfl ow s are regu lar or irregu lar.
For irregu lar pay m ents w e calcu late present v alu e by apply ing the
conv entional present v alu e form u la to each separate cashfl ow and
then su m m ing the present v alu es. This is represented by :
N
n
PV Cn 1 r B 21
n 1
w here C n is the cashfl ow m ade in Year n.

Consider a series of annu al cash pay m ents m ade u p of £100 in the
fi rst y ear and then increasing by £100 each y ear u ntil the fi fth y ear.
The present v alu e of this cashfl ow stream is:
1 2 3 4
PV 100 1 05 200 1 05 300 1 05 400 1 05
5
500 1 05
95 24 181 41 259 15 329 08 391 76
£1,256 64
330 APPENDIX B
The m ore frequ ently encou ntered ty pe of cashfl ow stream is an

annuity, regu lar annu al pay m ents w ith annu al discou nting. To cal-
cu late the present v alu e of an annu ity w e can u se a v ariation of
equ ation (B.16):
FV
PV
1 r N
1 rN 1 1
C
r 1 r N
1 1 r N
C B 22
r
Consider now an annu ity pay ing £5,000 each y ear for 20 y ears at an
interest rate 4.5% . The present v alu e of this annu ity is:
20
1 1 045
PV 5,000
0 045
65,039,68
We illu strate this principle u sing a 20-y ear annu ity that em ploy s
annu al discou nting. If a cashfl ow stream em ploy s m ore frequ ent
discou nting w e need to adju st the form u la again. If an annu ity
discou nts its cashfl ow s m tim es each y ear then the present v alu e
of its cashfl ow stream is fou nd u sing the present-v alu e-adju sted
equ ation – that is, equ ation (B.18). This becom es:
FV 1 1 r m mN
PV c B 23
r mN 1 r m m 1
1
m
If continu ou s discou nting is em ploy ed then this resu lts once again in
the lim iting factor for continu ou s discou nting, so w e adju st equ ation
(B.23) and the new ex pression is:
1 e rN
PV C B 24
er 1
The last case to consider is that of the pay m ents stream that has
m ore frequ ent cashfl ow s in addition to m ore frequ ent discou nting.
Su ch a pay m ents stream w ill hav e m cashfl ow s each y ear w hich are
also discou nted m tim es per y ear. To calcu late the present v alu e of
the cashfl ow s w e u se:
FV 1 1 r m mN
PV C B 25
1 r m mN r
APPENDIX B 331
The lim iting factor for continu ou s discou nting of continu ou s

pay m ents is:
1 e rN
PV C B 26
r
Pay m ent stream s that hav e cashfl ow frequ encies greater than
annu ally or sem i-annu ally occu r qu ite often in the m ark ets. To
illu strate how w e m ight u se equ ation (B.25), consider a m ortgage-
ty pe loan tak en ou t at the beginning of a period. If the borrow er is
able to fi x the interest rate being charged to the w hole life of the
m ortgage, she can calcu late the size of m onthly pay m ents requ ired
to pay off the loan at the end of the period.
For ex am ple, consider a repay m ent m ortgage of £76,000 tak en ou t for
25 y ears at a fi x ed rate of interest of 6.99% . The m onthly repay m ents
that w ou ld be charged can be calcu lated u sing equ ation (B.25) as:
C PV r
Ci B 27
12 12 1 1 r m 12 N
w here C i is the size of the m onthly pay m ent. Su bs titu ting the term s
of the m ortgage pay m ents into the equ ation w e obtain:
76,000 0 0699
Ci £536 67
12 1 1 0 0699 12 12 25
The m onthly repay m ent is therefore £536.67 and inclu des interest
chargeable in addition to repay m ent of som e of the principal (hence
the term repayment m ortgage, as opposed to endowment m ortgage
w hich only pay s off the m onthly interest charge). A repay m ent
m ortgage is also k now n as an amortized m ortgage. An am ortized
loan is one w here a proportion of the original loan capital is paid off
each y ear. Loans that requ ire the borrow er to serv ice the interest
charge once a y ear are k now n as straight or bullet loans. It is for this
reason that plain v anilla bonds are som etim es k now n as bu llet
bonds , since the capital elem ent of a loan raised throu gh a v anilla
bond issu e is repaid only on m atu rity .
Perpetual cashflow s
The ty pe of annu ity that w e as indiv idu als are m ost fam iliar w ith is
the annuity pension, pu rchased from a life assu rance com pany u sing
the proceeds of a pension fu nd at the tim e of retirem ent. Su ch an
annu ity pay s a fi x ed annu al cash am ou nt for an u ndeterm ined
332 APPENDIX B
period, u su ally u ntil the death of the benefi ciary . An annu ity w ith no
set fi nish date is k now n as a perpetuity. As the end date of a
perpetu ity is u nk now n w e are not able to calcu late its present
v alu e w ith certainty ; how ev er, a characteristic of the term
1 r N is that it approaches zero as N tends to infi nity . This
fact redu ces ou r present v alu e ex pression to:
C
PV B 28
r
We can u se this form u la to approx im ate the present v alu e of a
perpetu ity .
The UK gilt m ark et inclu des fou r gilts that hav e no redem ption date –
so-called undated bonds. The largest issu e am ongst u ndated gilts
is the 3 12 % w ar loan, a stock originally issu ed at the tim e of the
1914–1918 w ar. This bond pay s a cou pon of £3 12 per £100 nom inal
of stock . Since the cashfl ow stru ctu re of this bond m atches a per-
petu al, its present v alu e – u sing equ ation (B.28) w hen long-dated
m ark et interest rates are at, say , 5% – w ou ld be:
35
PV £70
0 05
The present v alu e of the cashfl ow stream represented by the w ar loan
stock w hen m ark et rates are 5% w ou ld therefore be £70 per £100
nom inal of stock . In fact, becau se this bond pay s cou pon on a sem i-
annu al basis w e shou ld adju st the calcu lation to accou nt for the m ore
frequ ent pay m ent of cou pons and discou nting, so the present v alu e
(price) of the bond is m ore accu rately described as:
C 3 1 75
PV
r 2 0 025
althou gh – as w e w ou ld ex pect – this still giv es u s a price of £70 per
£100 nom inal!
Corporate finance project appraisal

Tw o com m on techniqu es u sed by corporates and gov ernm ents to
ev alu ate w hether a project is w orth u ndertak ing are net present
value and internal rate of return. Both techniqu es ev alu ate the
anticipated cashfl ow s associated w ith a project, u sing the discou nt-
ing and present v alu e m ethods described in this chapter. Generally
speak ing, it is a com pany ’s cost of capital that is u sed as the discou nt
APPENDIX B 333
rate in project apprais al, and m ost com panies attem pt to ascertain
the tru e cost of their capital as accu rately as possible. As m ost
corporate fi nancing is u su ally a com plex m ix tu re of debt and
equ ity this is som etim es problem atic.
Net present value

In the case of an inv estm ent of fu nds m ade as part of a project,
w e w ou ld hav e a series of cashfl ow s – som e of w hich w ou ld be
positiv e and others negativ e. In the early stages of a project w e
w ou ld ty pically forecast negativ e cashfl ow s as a resu lt of inv est-
m ent ou tfl ow s, follow ed by positiv e cashfl ow s as the project
began to show a retu rn. Each cashfl ow can be present-v alu ed in
the u su al w ay . In project apprais al w e w ou ld seek to fi nd the
present v alu e of the entire stream of cashfl ow s; the su m of all
positiv e and negativ e present v alu es added together is the net
present value (NPV). As the apprais al process tak es place before
the project is u ndertak en, the fu tu re cashfl ow s that w e are concerned
w ith w ill be estim ated forecasts and m ay not actu ally be receiv ed
once the project is u nder w ay .
The net present v alu e equ ation is u sed to show that:
N
Cn
NPV B 29
n 1
1 r n
w here C n is the cashfl ow u sed for the project du ring period N .

The rate r u sed to discou nt cashfl ow s can be the com pany ’s cost
of capital or the rate of retu rn requ ired by the com pany to m ak e the
project v iable.
Com panies w ill apply NPV analy sis to ex pected projected retu rns
becau se fu nds inv ested in any u ndertak ing hav e a tim e-related cost –
the opportu nity cost that is the corporate cost of capital. In effect,
NPV m easu res the present v alu e of the gain achiev ed from inv esting
in the project (prov ided that it is su ccess fu l!). The general ru le of
thu m b applied is that any project w ith a positiv e NPV is w orthw hile,
w hereas those w ith a negativ e NPV, discou nted at the requ ired rate
of retu rn or the cost of capital, shou ld be av oided.
334 APPENDIX B
Example B.1
What is the NPV of the follow ing set of ex pected cashfl ow s,

discou nted at a rate of 15% ?
Year 0 £23,000
Year 1 £8,000
Year 2 £8,000
Year 3 £8,000
Year 4 £11,000
8,000 8,000 8,000 11,000
NPV 23,000 £1,554
1 15 1 15 2 1 15 3 1 15 4
The internal rate of return

The internal rate of retu rn (IRR) for an inv estm ent is the discou nt
rate that equ ates the present v alu e of ex pected cashfl ow s (the NPV)
to zero. Using the present v alu e ex pression w e can represent it by
rate r su ch that:
N
Cn
0 B 30
n 0
1 r n
w here
Cn Cashfl ow for the period N ;
n Last period in w hich a cashfl ow is ex pected; and
Su m of discou nted cashfl ow s at the end of periods 0
throu gh n.
If the initial cashfl ow occu rs at tim e 0, equ ation (B.30) can be ex -
pressed as:
C1 C2 CN
C0 B 31
1 r 1 r 2 1 r N
In corporate fi nance project apprais al, C 0 is a cash ou tfl ow and C 1 to

C N are cash infl ow s. Thu s, r is the rate that discou nts the stream of
fu tu re cashfl ow s (C 1 throu gh C n) to equ al the initial ou tlay at tim e 0.
We m u st therefore assu m e that the cashfl ow s receiv ed are su bse-
qu ently reinv es ted to realize the sam e rate of retu rn as r. Solv ing for
the internal rate of retu rn, r cannot be fou nd analy tically and has to
be fou nd either throu gh nu m erical iteration or u sing a com pu ter or
program m able calcu lator.
APPENDIX B 335
To illu strate the IRR consider the project cashfl ow s giv en in

Ex am ple B.1. If w e w is h to fi nd the IRR long hand then w e w ou ld
hav e to obtain the NPV u s ing different discou nt rates u ntil w e fou nd
the rate that gav e an NPV equ al to zero. The qu ick est w ay to do this
m anu ally is to select tw o discou nt rates, one giv ing a negativ e NPV
and the other a positiv e NPV, and then interpolate betw een them .
This m ethod of solv ing for IRR is k now n as an iterativ e process and
inv olv es conv erging on a solu tion throu gh trial and error. This is in
fact the only w ay to calcu late the IRR for a set of cashfl ow s; it
m atches ex actly the iterativ e process that a com pu ter u s es (the
com pu ter is ju st a tou ch qu ick er!). If w e hav e tw o discou nt rates
– say , x and y that giv e positiv e and negativ e NPVs, respectiv ely , for a
set of cashfl ow s – the IRR can be estim ated u sing:
IRR estim ate x% y% x%

Positiv e NPV v alu e
B 32
Negativ e NPV v alu e NPV v alu e
Example B.2
Using a discou nt rate of 15% produ ced a positiv e NPV in Ex am ple

B.1. Discou nting the cashfl ow s at 19% produ ces an NPV of £395.
Therefore, the estim ate for IRR is:
15% 4% 1,554 1,554 395 18 19%
The IRR is approx im ately 18.19% . This can be check ed u sing a
program m able calcu lator or spreadsheet program m e; it m ay also
be check ed m anu ally by calcu lating the NPV of the original
cashfl ow s u sing a discou nt rate of 18.19% – it shou ld com e to
£23,000. We obtain an IRR of 18.14% u sing a calcu lator.
The relationship betw een the IRR and the NPV of an inv estm ent can
be su m m ed u p as follow s: w hile the NPV is the v alu e of projected
retu rns from the inv estm ent u sing an appropriate discou nt rate
(u su ally the com pany ’s cost of capital), the IRR is the discou nt
rate w hich resu lts in the NPV being zero. For this reason it is
com m on to hear the IRR referred to as a project’s breakeven rate.
A conv entional inv estm ent is considered attractiv e if the IRR
ex ceeds a com pany ’ s cost of capital and the NPV is positiv e. In
the contex t of bond m ark ets, as long as the discou nt rate applicable
does indeed rem ain constant for the reinv es tm ent of all cashfl ow s
336 APPENDIX B
arising from a fi nancial instru m ent, the IRR can then be assu m ed to
be the yield to maturity for that instru m ent. Yield to m atu rity is the
m ain m easu re of the rate of retu rn achiev ed from holding a bond.
Interpolation and ex trapolation

Interest rates in the m oney m ark ets are alw ay s qu oted for standard
m atu rities: for ex am ple, ov ernight, ‘tom nex t’ (the ov ernight interest
rate starting tom orrow , or ‘tom orrow to the nex t’), spot nex t (the
ov ernight rate starting 2 day s forw ard), 1 w eek , 1 m onth, 2 m onths
and so on u p to 1 y ear. Figu re B.1 show s a ty pical brok ers’ screen as
seen on new s serv ices su ch as Reu ters and Telerate.
If a bank or corporate cu stom er w ishes to deal for non-standard
periods, an inter-bank desk w ill calcu late the rate chargeable for
su ch an ‘odd date’ by interpolating betw een tw o standard period
interest rates. If w e assu m e that the rate for all dates in betw een
tw o periods increases at the sam e pace, w e can calcu late the requ ired
rate u sing the form u la for straight line interpolation:
n n1
r r1 r2 r1 B 33
n2 n1
w here
r Requ ired odd date rate for n day s;
r1 Qu oted rate for n1 day s;
r2 Qu oted rate for n2 day s.
Figure B.1 A ty pical brok ers’ screen.

APPENDIX B 337
Let u s im agine that the 1-m onth (30-day ) offered interest rate is
5.25% and the 2-m onth (60-date) offered rate is 5.75% . If a cu stom er
w is hes to borrow m oney for a 40-day period, w hat rate shou ld the
bank charge? We can calcu late the requ ired 40-day rate u sing straight
line interpolation. The increase in interest rates from 30 to 40 day s is
assu m ed to be 10/30 of the total increase in rates from 30 to 60 day s.
The 40-day offered rate w ou ld therefore be:
5 25 5 75 5 25 10 30 5 4167%
Example B.3
An inter-bank desk is qu oting the 7-day offered rate (the rate at

w hich a bank w ill offer or lend m oney ) at 5 1116 % , w hile the 14-day
rate is 5 13
16 % . What rate shou ld he qu ote for the 10-day offered rate?
5 6875 5 8125 5 6875 3 7 5 7411%
What abou t the case of an interest rate for a period that lies ju st before
or ju st after tw o k now n rates – bu t not in betw een them ? When this
happens w e extrapolate betw een the tw o k now n rates, again assu m -
ing a straight line relationship betw een them , and for a period after
(or before) the tw o rates.
Example B.4
The 1-m onth offered rate is 5.25% w hile the 2-m onth rate is 5.75%
as before. What is the 64-day rate?
5 25 5 75 5 25 34 30 5 8167%
By Moorad Choudhry
Appendix
C
ABBREVIATIONS
AND ACRONYMS
340 APPENDIX C
ABCP Ass et-Back ed Com m ercial Paper

ABS Ass et-Back ed Secu rity
AER Annu al Equ iv alent Rate
ALCO Ass et–Liability COm m ittee
ALM Ass et Liability Managem ent
AMA Adv anced Measu rem ent Approach
APR Annu alized Percentage Rate
ASW Ass et Sw ap Spread
BAU Bu s iness As Usu al
BBA British Bank ers Ass ociation
BCBS Basel Com m ittee for Bank ing Su perv ision
BIA Basic Indicator Approach
BIS Bank for International Settlem ents
CA Capital Allocation
CD Certifi cate of Deposit
CDO Collateralized Debt Obligation
CDS Credit Defau lt Sw ap
CP Com m ercial Paper
CRD Capital Requ irem ents Directiv e
DV01 Dollar Valu e of loss for a 1 bp rise in y ields
EAD Ex pos u re At Defau lt
ECAI Ex ternal Credit Assessm ent Institu tion
ECB Eu ropean Central Bank
ECP Eu ro Com m ercial Paper
EEA Eu ropean Econom ic Area
EURIBOR Eu ro Interbank Offered Rate
FI Fix ed Incom e
FRA Forw ard Rate Agreem ent
FRN Floating Rate Note
FSA Financial Serv ices Au thority
FtD First-to-Defau lt
FX Foreign eXchange
GC General Collateral
GMRA Global Master Repu rchase Agreem ent
IAA Internal Assessm ent Approach
IR Interest Rate
IRB Internal Ratings Based
IRR Internal Rate of Retu rn
ISDA International Sw aps and Deriv ativ es
Ass ociation
LAB Liqu id Asset Bu ffer
LG Letter of Gu arantee
LGD Los s Giv en Defau lt
APPENDIX C 341
LIBID London Interbank BID Rate

LIBOR London InterBank Offered Rate
LIFFE London International Financial Fu tu res
Ex change
LRF Liqu idity Risk Factor
LTD Loan To Deposit
LTV Loan To Valu e
M Matu rity
MATIF French Fu tu res Ex change
MPC Monetary Policy Com m ittee
MTN Mediu m -Term Note
NED Non-Ex ecu tiv e Director
NIBL Non-Interest-Bearing Liability
NII Net Interest Incom e
NPL Non-Perform ing Loan
NPV Net Present Valu e
NSFR Net Stable Fu nding Ratio
OBS Off Balance Sheet
OIS Ov ernight Index Sw ap
OTC Ov er The Cou nter
P&L Profi t & Loss
PD Probability of Defau lt
PF Persistence Factor
PIBS Perm anent Interest-Bearing Share
PSA/ISMA Pu blic Secu rities Association/International
Secu rities Mark et Association
PVBP Present Valu e of a Basis Point
RBA Ratings-Based Approach
RMBS Residential Mortgage-Back ed Secu rity
ROA Retu rn On Assets
ROC Retu rn On Capital
ROE Retu rn On Equ ity
RPI Retail Prices Index
SA Standardized Approach
SBU Strategic Bu sines s Unit
SF Su perv isory Form u la
SIV Stru ctu red Inv estm ent Vehicle also known as
Special Inv estm ent Vehicle
SONIA Sterling Ov erNight Interest rate Av erage
SPC Special Pu rpose Corporation
SPV Special Pu rpose Vehicle
TLP Transfer Liqu idity Pricing, also k now n as
Term Liqu idity Prem iu m
342 APPENDIX C
TP Transfer Price
TRS Total Retu rn Sw ap
USCP US Com m ercial Paper
WACC Weighted Av erage Cost of Capital
By Moorad Choudhry
INDEX
ABCP see asset-back ed com m ercial asset and liability m anagem ent
paper (ALM) 2, 143 232
accru al pricing 62 bank ing book 12, 180 1
agenda, ALM 225 6 basic concepts 144 7, 169 74
ALCO see asset and liability capital m anagem ent 9
com m ittee cornerstone philosophy 144 5
ALM see asset and liability deriv ativ e trading hou se 146 7
m anagem ent desk /u nit 180 2, 184
annu alized interest rates 321 dev elopm ents 184 5
annu ities 86 7, 331 2 ex am ple 171 3
arbitrage 75 fou ndations 170 3
asset and liability com m ittee gap 146 53
(ALCO) 175, 223 32 interest rate risk 144 6, 174 80,
agenda 225 6 185 98
ALM policy 212 19
dev elopm ents 184 5 roles of desk 184
policy 213 17 secu ritization 202 19
report 224 5, 227 traditional 182 4, 198 202
bu siness planning 226 v alu e-at-risk 219 20
hedging 226 7, 229 see also asset and liability
interest rate risk 175 com m ittee; liqu idity ; net
internal fu nding policy 259 present v alu e
large bank s 217 asset-enru le;back ed com m ercial
m anagem ent reporting 226 7 paper (ABCP) 40, 43 8
m ediu m bank s 215 16 characteristics 44 6
m em bers 214 15, 224 5 condu its 44 6
objectiv es 214 15 stru ctu re illu stration 46 8
policy 224 7, 259 assets
regu lar discu ssion points 214 Basel II 298 302
reporting 224 32 core/non-core 265
sim u lation m odelling 218 19 fi x ed-rate 194 5
sm all bank s 214 internal fu nding policy 258
strategic ov erv iew 225 liqu idity gap 147 53, 185 6
344 INDEX
assets (cont.) IRB approaches 286 304

liqu idity ratio 156 7 m inim u m capital requ irem ents
m atu rity 146 7, 168 9, 171 286 7
pricing 258 operational risk 288 9
ROC 254 5 ov erv iew 286
short-term debt 298 9 pu blic disclosu re 287
w eighted risk 284, 295, 299 300 retail lending 302 4
see also asset sector-specifi c im pact 289 304
Atk inson, Pau l 255 sov ereign bu siness 289 90, 292 8
su perv isory process 287
back -u p facilities 311 three-pillar approach 286 7
balance sheets 13 14 Basel III ru les 273 6, 304 6
com ponents 14 initial im pact 305 6
liqu idity policy 238 new bu siness m odel 234, 263,
secu ritization 203 265, 267
bancassurance grou ps 18 prov isions 304 5
bank bills see bank er’s acceptances Basel ru les 283 306
Bank of England bank ing capital 10
capital stru ctu re 269 Basel I 284 6, 290 1
report 2009 269 Basel II 133 4, 285 304
y ield cu rv e 82 3 Basel III 234, 263, 265, 267,
Bank for International Settlem ents 273 6, 304 6
(BIS) 10, 234, 282 3 Basel ratio 283
bank er’s acceptances 37 9 basis risk 176 7
bank ing book 10 12, 180 1 BBA see British Bank ers’
Basel I 285 Association
Basel III 305 6 BBAM Bloom berg screen 28
liqu idity gap 173 4, 178, 187 BCBS see Basel Com m ittee for
PVBP reports 196 Bank ing Su perv ision
sim u lation m odelling 218 benchm ark bonds 71
Basel Accord 1988 283 4 bills of ex change see bank er’s
Basel Com m ittee for Bank ing acceptances
Su perv ision (BCBS) 266, 273 6, BIS see Bank for International
283, 304 5 Settlem ents
Basel I ru les black box m odels 130, 133 4, 139
Basel II 286, 290 1 Bloom berg screens 25 7
capital adequ acy 284 5 BBAM 28
capital requ irem ent lev el 285 BSR 59 60
capital ty pes 284 DCX 26 7
risk -adju sted ex posu re 285 DES 106
Basel II ru les 285 304 GP 35
bank assets 298 302 RRRA 54 6
Basel I 286, 290 1 Tu llett & Tok y o 32 3
corporate lending 302 4 Blu ndell-Wignall, Adrian 255
credit rating 133 4 bonds
credit risk 287 8 benchm ark 71
INDEX 345
capital-raising 7 m ark et stability 278

Eu robonds 7 new m odel 262 73
interest rate fu tu res 107 recom m endations 278 9
LAB 276 7 su stainable m odels 261 79
relativ e v alu es 70, 86 bu y and hold 11
segm entation hy pothesis 79 bu y sell see sell/bu y back
sov ereign 158 66 bu y back see sell/bu y back
strip 72
u ndated 332 capital 1 21
zero-cou pon 72, 83 4 adequ acy 181, 284 5
see also gov ernm ent bonds; y ield ALM reporting 183
cu rv e analy sis ratios 11
boot-strapping 86 Basel ru les 10
borrow ers 5 6 borrow er/lender confl ict 5 6
Bradford & Bingley 252 capitalraising 6 7
break ev en principle 85, 88 91, 115 cou ntercy clical bu ffer 305 6
British Bank ers’ Association (BBA) defi nition 283
28, 112, 274 effi cient m anagem ent 9
BSR Bloom berg 59 60 m ark ets 5 8
bu ilding societies ratios 11, 181, 267, 269, 283
earnings chart 16 ROC 8, 254 5
orthodox behav iou r 279 stru ctu re 268 70, 279
segm entation hy pothesis 78 9 WACC 200 2
bu siness activ ities 1 21 see also regu latory capital
capital m ark ets 5 8 capital stru ctu re 268 70
com m ission 4 bu siness m odels 268 70
fees 4, 17 18 contingent capital 268 9
fi nancial statem ents 13 21 desirable capital ratios 269
list of activ ities 3 sim plifi cation 279
operating costs 5 cashfl ow s 127 9, 191, 194, 327 37
scope 8 13 see also m atched book approach
serv ices 3 certifi cates of deposit (CDs) 29 34
trading incom e 4 5 credit interm ediation 98 100
traditional institu tions 2 3 day s rem aining 31
see also net interest incom e; Eu ro-CDs 30
ratios; trading book ex am ple 32
’The bu siness of bank ing’ (The m oney m ark ets 25, 29 34
Economist) 168 secondary m ark ets 31
bu siness m odel 261 79 tenor 31
bank strategy 263 5 y ield 30 4
capital stru ctu re 268 70, 279 classic repos 50 6
core com petencies 270 1 Bloom berg screen 54 6
historical m odel 262 3 ex am ples 52 6
lev erage ratios 265 8 illu stration 50 2
liqu id asset bu ffer 276 7 legal treatm ent 62
liqu idity risk m anagem ent 271 6 ’legs’ term inology 51 2
346 INDEX
classic repos (cont.) credit interm ediation 98 100, 102

repo rate 51 credit lim its 135 9
rev erse 52 3 ancillary bu siness 138
term s of trade 53 credit process 136
trade diagram 53 defau lt 137
transaction diagram s 52, 57 ’k now y ou r risk ’ dictu m 136 7
clean deposits see m oney m ark et lim it categories 138 9
deposits lim it ex cess 139
collateral 49 50, 52, 60 2 m acro-lev el lim its 138
com m ercial bills see bank er’s portfolio div ersifi cation 137
acceptances principles 136 8
com m ercial letters of credit 310 rationale 135 9
com m ercial paper (CP) 39 48 setting 135 9
ABCP 40, 43 8 credit ratings 133 5
day -cou nt conv ention 42 bank internal ratings 133 5
ex am ple 42 3 Basel I 133 5
issu ance m ethods 41 Basel II 133 5, 292, 299 300
liqu idity gap 149 credit lim its 137
m ark ets 39 40 foreign cou ntries 134
program m es 40 1 rationale 133 5
US CP/ECP 40 1 secu ritization 206
y ield 42 3 short-term debt 299 300
com m ission 4, 17 18 see also internal ratings-based
com petencies 264 5, 270 1 approaches
com pou nd interest 319 21, 326 credit risk 129 41
concentration report 250 asset ex posu re 131 3
condu its 44 6 Basel II 287 8
see also special pu rpose v ehicles credit lim its 135 9
contingent capital 268 9 credit rating 133 5
contingent liabilities 13 defau lt 130 1, 134 5, 137, 140 1
Cook e ratio 283 defi nition 130 1
corporate lending 302 4 hedging 129 41
corporate project appraisals 332 3 interest rate sw aps 123
costs loan origination 139 41
bank operations 5 m igration risk 132
cost/incom e ratios 19 20 MtM v alu ation 131 3
fu nding costs 199 207, 255 6 u nderstanding 130 3
internal fu nding 255 6 credit-su pported com m ercial paper
secu ritization 206 7 40
traditional ALM 200 2 cross-border lending fl ow s 270
WACC 200 2 cu m u lativ e liqu idity m odel 247,
cou ntercy clical capital bu ffer 305 6 249, 253, 274 5
cou pons 57, 60 2 cu rrency day -cou nt base 65
CP see com m ercial paper cu rrent accou nts 308
creating a tail 96 7 cu stom er deposits 241 2
’credit card’ bank s 206 cu stom er k now ledge 139 40
INDEX 347
day -cou nt conv ention 25, 42, 65 eligible bank er’s acceptances 38 9
day s rem aining, CDs 31 Eu ro-CDs 30
DCX Bloom berg screen 26 7 Eu robonds 7
defau lt Eu rocom m ercial CP (ECP) 40, 42
loan origination 140 1 Eu rodollar fu tu res 105 6
PD 134 5, 288, 293 8, 301, ex pectations hy pothesis 73 6
303 4 local 73 4, 76
risk 171 retu rn-to-m atu rity 73, 76
sov ereign bu siness 293 8 u nbiased 73 6
delta-VaR v olatility calcu lation 220 y ield-to-m atu rity 73, 76
dem and deposits 192 3, 308 ex pected loss (EL) 135
deriv ativ es ex penses 18 19
Basel II 301 2 ex posu re at defau lt (EAD) 288,
gap m anagem ent 170, 174 294 5, 301, 303
m oney m ark ets 24 ex ternal credit assessm ent
Ru binstein 74 institu tions (ECAIs) 292 3
trading book 13 ex trapolation 336 7
trading hou se ALM profi le 146 7
y ield cu rv e 70 federal fu nds 34 5, 126 9
DES Bloom berg screen 106 fees 4, 17 18
desk , ALM 180 2 Financial Serv ices Au thority (FSA)
disclosu re of inform ation 287 consu ltativ e papers 271 2
discou nt LAB 276 7
CP 39 new proposals 271 2
factors 87 8, 323 7 Policy Statement 09/16 271, 276
as qu otation basis 25, 34 9 stress tests 272 3
rates 36 7, 72 UK 252
T-bills 36 7 fi nancial statem ents 13 21
zero-cou pon y ield cu rv e 87 8 balance sheets 13 14
dollars P&L report 14 21
DV01 reports 195, 227 fi x ed rates
Eu rodollar fu tu res 105 6 assets 194 5
Singapore dollars 26 7 interest rate sw aps 117, 121 2
US m ark et 26, 33 4 liabilities 194 5
du ration gap 184, 197 8 m ortgages 117 19
DV01 reports 195, 227 fl at y ield cu rv e 73, 80
dy nam ic gap 150 fl oating rate notes (FRNs) 309
fl oating rates
EAD see ex posu re at defau lt assets 151
earnings com position charts 16 FRNs 309
ECAIs see ex ternal credit liabilities 151
assessm ent institu tions forw ard pricing 56 60
The Economist 168 forw ard rate agreem ents (FRAs) 105,
ECP see Eu rocom m ercial CP 110 29
effectiv e interest rates 321 2 defi nition 111 12
EL see ex pected loss ex am ple 112
348 INDEX
forw ard rate agreem ents (cont.) gap

hedging 110 29 ALM 146 53
interest rate sw aps 117 29 analy sis 178 80, 183 4, 198
k ey dates 113 du ration 184, 197 8
m echanics 112 17 historical bank m odel 263
’notional’ cash 110 11 interest 170
pricing 115 17 interest rate 146, 170, 194 7,
settlem ent 113 15 227 8
standard term s 112 13 liqu idity 146 53, 185 98
forw ard rates m anagem ent 170, 173 4
break ev en principle 88 91 m argin 186, 195 6
FRAs 105, 110 29 m atu rity 187 91, 198 9
fu tu res 105 NII 178 9
m oney m ark et term 91 2 ratio 183
points to note 92 3 reports 195 6, 217 18
y ield cu rv e 88 93 repricing interv als 198
FRAs see forw ard rate agreem ents risk 176, 247
frictionless m ark ets 80 traditional ALM 198 9
general collateral (GC)
FRNs see fl oating rate notes
classic repos 52
FSA see Financial Serv ices
credit interm ediation 98 9
Au thority
repos 52, 61, 98 9, 101
fu nding
specials trading 101
concentration report 275
gilts
costs 199 207, 255 6
credit interm ediation 98 100
federal fu nds 34 5, 126 9
liqu idity portfolio 162 6
hedging 125 7
u ndated bonds 332
illiqu id assets 241 4 gov ernm ent bonds 61, 69, 308 9
inter-entity fu nding report 275 gilts 98 100, 162 6, 332
liqu idity m anagem ent 153 6 liqu idity risk 242
liqu idity policy 238 repo collateral 61
long/short 96 7 y ield cu rv e 69
net stable fu nding ratio 273 6 see also sov ereign bu siness
policy 252 9, 273 6 GP Bloom berg screen 35
secu ritization 206 7
sou rce report 250 1 haircu ts 62 3
traditional ALM 182 3, 199 205 see also m argin
w holesale 242 HBOS 55
see also internal fu nding policy hedging 95 141
fu tu re v alu es 327 9 ALCO 226 7, 229
fu tu res ALM reporting 183
deliv ery 104 credit risk 129 41
Eu rodollar 105 6 FRAs 110 29
interest rate 70, 103 10, 158 60 interest rate 158 62
short sterling 104 5 fu tu res 103 10
see also interest rate fu tu res risk 181
INDEX 349
sw aps 117 29 ALCO reporting 227 8

tools 103 29 ALM gap 146
liqu idity 181 calcu lation of 194 5
OISs 125 7 gap reports 195 6
policy 226 7 liqu idity gap 196
traditional ALM 183 interest rate risk 144 6, 174 82,
holding period retu rns 74 185 98
HSBC 241 ALM policy 216 18
hu m ped y ield cu rv e 71 2, 77 bank ing book 180 1
basis risk 176 7
incom e gap analy sis 178 80
ALCO reports 230 2 gap risk 176
com m ission 4, 17 18 interest rate gap 194 7
cost/incom e ratios 19 20 m anagem ent 217
fees 4, 17 18 m easu rem ent 217 18
reports 230 2 NII 4, 178 9
risk 174 option risk 177 8
statem ents 15 ru noff risk 177
trading 4 5, 18 secu ritization 216 18
see also net interest incom e sou rces 175 8
increm ental gap 150 traditional ALM 182
infl ation 77 y ield cu rv e risk 176
insu rance 237 interest rate sw aps 117 29
inter-entity fu nding report 251, 253, com parativ e adv antage 118 20
275 descriptions 118, 120
interest fi x ed/fl oating rate 117, 121 2
calcu lations 25 7 hedging 117 29
cashfl ow s 194 m ortgages 117 20
gap 170 ov ernight 123 9
m argin 170 qu otes table 123
m oney m ark ets 25 7 secondary m ark ets 120 1
see also net interest incom e SONIA 124
interest-bearing cu rrent accou nts stru ctu re 118 20
308 sw ap spreads 122 3
interest rate fu tu res 103 10 v anilla sw aps 117, 121 2
Bloom berg screen 106 y ield cu rv e 70, 82, 122 3
conv ergence 105 interest rates
description 103 5 ALCO reporting 230
Eu rodollar contract 105 6 annu alized 321
ex am ples 105 10 com pou nd interest 319 21, 326
hedging 103 10, 158 60 conv entions 322 3
LIFFE ex change 103 4 deriv ativ es 70
pricing 70 effectiv e 321 2
short sterling 104 5 ex pectations 96 8
tick v alu es 104 5 FRAs 110 29
interest rate gap 170, 194 7 fu tu res 70, 103 10, 158 60
350 INDEX
interest rates (cont.) Jarrow , Robert 74

gap 194 7, 227 8
hedging 103 29, 158 62, 181 LAB see liqu id asset bu ffer
m atched book trading 102 large bank s 216 18
prim e rate 34 Lehm an Brothers 157 8, 234, 242,
reports 230 266
’risk ’ free 70 lenders 5 6
sensitiv ity 171, 178, 198, 214 letters of credit (LoCs) 40 1,
sim ple interest 318, 326 309 11
sw aps 70, 80, 117 29 lev erage
term stru ctu re 69, 84, 171 historical bank m odel 263
trading 96 8, 103 29 lev eraged loans 312 15
traditional ALM 198 ratios 265 8, 306
y ield cu rv e 68 lev erage ratios 265 8
see also interest rate risk Basel III 306
internal fu nding policy 252 9 capital ratios 267
ALCO responsibilities 259 lim iting lev erage 267 8
asset pricing 258 m edian ratios 2007 2009 266
best practice 256 7 LGD see loss giv en defau lt
cost of fu nds 255 6 liabilities
fram ew ork 252, 254 5, 257 9 contingent 13
liability pricing 258 9 ex cess 155
liqu idity prem iu m 257, 259 fi x ed-rate 194 5
liqu idity risk 252 9 internal fu nding 258 9
ongoing basis 259 liqu idity gap 147 53, 185 6
ROC 254 5 liqu idity ratio 156 7
scope 257 m atu rity 168 9, 171
transfer pricing 257 NIBLs 153, 177, 190, 192
internal rate of retu rn (IRR) 334 6 pricing 258 9
internal ratings-based (IRB) see also asset and liability
approaches 286 304 m anagem ent
Basel II 286 304 LIBID bid rate 28, 255
corporate lending 302 4 LIBOR
credit risk 287 8 internal fu nding 255 6
retail lending 302 4 m oney m ark ets 27 8, 35
sov ereign bu siness 292 8 US dollars 2005 35
interpolation 336 7 LIFFE fu tu res ex change 103 4, 117
inv erted y ield cu rv e 71 2, 81 2, liqu id asset bu ffer (LAB) 276 8
97 8 best practice 278
inv estm ent-grade credit ratings 206 com ponent instru m ents 276 7
inv estm ent risk 174 liqu idity portfolio 158
IRB approaches see internal ratings- liqu idity 169 71
based approaches bank ing book 180 1
IRR see internal rate of retu rn facilities 311
Italy 57 historical bank m odel 263
INDEX 351
reports 246, 248, 250 2 internal fu nding policy 257, 259

secu ritization 216 y ield cu rv e 77 8
liqu idity gap 147 53, 185 91 see also transfer price
cash m atching 191 liqu idity ratios 156 7, 245 9, 247,
defi nition 148 51 253
Eu ropean bank profi le 150 1 liqu idity risk 144 5, 151, 233 59
ex am ple profi les 186 91 access to facilities 243
gap risk /lim its 186 91 Basel III 273 6
gu idelines 149 bu siness m odel 271 6
illu stration 148 51 contingency plans 243
interest rate gap 196 core cu stom er deposits 241 2
liqu idity risk 151 dealing w ith stresses 242 3
m anagem ent 149, 152 3 ex posu re aw areness 243
m arginal gap 150 factor 249 50, 253, 275
m atched book 152, 156 FSA proposals 271 2
m atching assets/liabilities 148 fu nding illiqu id assets 241 4
reports 186 7 indicator u sage 244
tim e issu es 148 9 internal fu nding 252 9
u ndated assets/liabilities 152 3 k ey m etrics 244 52
see also gap liqu idity bu ffers 242 3
liqu idity m anagem ent 173 4, m anagem ent 233 59, 271 6
192 4 m etrics 273 6
basic case 153 6 m onthly snapshot 253
dem and deposits 192 3 new m odel 271 3
fu nding gap 153 6 NSFR 273 6
illu stration 155 6 policy statem ent 234 40
interest cashfl ow s 194 stress-testing 272 3
liqu idity gap 185 transfer-pricing 244
prepay m ent options 193 4 w holesale fu nds 242
preset contingencies 193 liqu idity risk factor (LRF) 249 50,
traditional ALM 182 3 253, 275
liqu idity policy 234 40 Lloy ds Bank ing Grou p 269
balance sheet changes 238 loan origination 139 41
basic fram ew ork 235 40 black box m odels 139
categorizing risk 237 defau lt 140 1
fu nding options 238 failed UK bank s 139
m anagem ent process 239 gu idelines 139 40
risk appetite 236 k now ing the cu stom er 139 40
su m m ary tem plate 240 loan secu rity 140
ty pes of risk 237 standards 139 41
liqu idity portfolio 157 66 su bprim e lending restrictions 140
ex am ples 158 66 loan-to-deposit ratio (LTD) 245, 247,
liqu id asset bu ffer 158 253, 274
liqu idity preference theory 76 8 local ex pectations hy pothesis 73 4,
liqu idity prem iu m 76
calcu lation m ethodology 259 LoCs see letters of credit
352 INDEX
London Interbank Offered Rate see m odifi ed du ration 197 8

LIBOR m oney m ark ets 23 65
loss giv en defau lt (LGD) 288, 293 7, CDs 29 34
301, 303 com m ercial paper 39 48
LRF see liqu idity risk factor day -cou nt conv ention 25, 65
LTD see loan-to-deposit ratio deposits 27 9
deriv ativ es 24
M see m atu rity discou nt-basis secu rities 25, 34 9
m argin forw ard rates 91 2
ALCO reporting 230 1 interest calcu lations 25 7
gap 150, 186, 195 6 issu ers 24
initial 62 3 repos 48 64
interest 170 y ield-basis secu rities 25, 27 34
m aintenance lim it 64 Morgan Stanley 3
repos 62 4 m ortgages 117 20
v ariation 57, 64 MtM see m ark to m ark et
m ark to m ark et (MtM) 131 3, 195, m u ltiple cashfl ow s 327 37
220 corporate projects 332 3
m ark ets ex trapolation 336 7
bu siness m odel 278 fu tu re v alu es 327 9
capital 5 8
interpolation 336 7
CP 39 40
IRR 334 6
credit risk 130
NPV 333 5
m oney m ark ets 23 65
perpetu al cashfl ow s 331 2
perfect m ark ets 80 1
present v alu es 329 31
risk 4, 17 18
m u ltiple discou nting 326 7
secondary 31, 120 1
stability 278
US dollar rates 33 4 negativ e y ield cu rv e see inv erted
m atched book y ield cu rv e
cash m apping 191 net interest incom e (NII) 4
liqu idity gap 152, 156 gap 178 9
trading 102 3 operational risk 288 9
m atu rity (M) P&L report 15 17
assets 146 7, 168 9, 171 sim u lation m odelling 218
Basel II 301 net present v alu e (NPV) 145 6,
bu ck ets 178 333 5
gap 187 91, 198 9 du ration gap 197
liabilities 168 9, 171 gap reports 195
regu latory capital 294 5, 297, 303 sensitiv ity 219
transform ation 157, 262, 275 v olatility 219 20
see also liqu idity risk factor net stable fu nding ratio (NSFR)
m ediu m -sized bank s 215 16, 234 273 6
m igration risk 132 NIBLs see non-interest-bearing
Modelling Fixed Income Securities liabilities
(Jarrow ) 74 NII see net interest incom e
INDEX 353
non-interest-bearing cu rrent policy

accou nts 308 ALCO 224 7, 226 7
non-interest-bearing liabilities hedging 226 7
(NIBLs) 153, 177, 190, 192 internal fu nding 252 9
non-interest incom e 17 18 liqu idity 234 40, 252 9
non-perform ing loans (NPLs) 131 secu ritization 212 19
Northern Rock 241, 252 Policy Statement 09/16, FSA 271,
notes, FRNs 309 276
NPLs see non-perform ing loans portfolios
NPV see net present v alu e div ersifi cation 137
NSFR see net stable fu nding ratio du ration gap 197 8
liqu idity 157 66
OECD see Organization for position m anagem ent 210 12
Econom ic Cooperation and positiv e y ield cu rv e 9 7
Dev elopm ent preferred habitat theory 79 80
off-balance-sheet instru m ents 13, prepay m ent options 193 4
18 present v alu e of a basis point report
see also deriv ativ es see PVBP report
OISs see ov ernight index ed sw aps present v alu es
operations m u ltiple cashfl ow s 329 31
costs 5 m u ltiple discou nting 326 7
env ironm ent 264 PVBP reports 195 6
ex penses 18 19 see also net present v alu es
risk 288 9 price/pricing
option risk 177 8 accru al pricing 62
Organization for Econom ic assets 258
Cooperation and Dev elopm ent deriv ativ es 70
(OECD) 289, 292 3, 296 forw ard pricing 56 60
ov ercollateralization 62 FRAs 115 17
see also m argin gap analy sis 198
ov ernight index ed sw aps (OISs) interest rate fu tu res 70
125 9 liabilities 258 9
cashfl ow s 127 9 risk 174
ex am ples 125 9 sell/bu y back s 56 60
hedging fu nding 125 7 T-bills 36 7
ov ernight interest rate sw aps 123 9 transfer price 244, 255, 257
y ield cu rv e 69 70
P&L report see profi t and loss report prim e interest rate 34
PD see probability of defau lt probability of defau lt (PD) 134 5,
pensions 331 2 288, 293 8, 301, 303 4
perfect m ark ets 80 1 profi t and loss (P&L) report 14 21
periodic gap 179 com m ission incom e 17 18
perpetu al cashfl ow s 331 2 cost/incom e ratios 19 20
plain v anilla interest rate sw aps fee incom e 17 18
117, 121 2 NII 15 17
planning, ALCO 226 operating ex penses 18 19
354 INDEX
profi t and loss report (cont.) su m m ary liqu idity report 252
prov isions 19 21 traditional ALM 183
trading incom e 18 ty pe of interest rate 230
project appraisals 332 3 w eek ly qu alitativ e 275
prov isions 19 21 repos 25, 48 64
pu re ex pectations hy pothesis 74 Basel II 301
PVBP reports 195 6 classic repo 50 6
collateral 49 50, 52, 60 2
ratings see credit ratings; internal credit interm ediation 98 100
ratings-based approaches defi nitions 49 50, 52
ratios 11, 13 21 legal treatm ent 62
Basel 283 liqu idity portfolio 158 60
capital 11, 181, 267, 269, 283 m argin 62 4
cost/incom e 19 20 m atched book 102 3
gap 183 repo dealers 98 9
lev erage 265 8, 306 repo rate 49, 51, 100
liqu idity 156 7, 245 9, 247, 253 sell/bu y back 56 60
LTD 245, 247, 253, 274 special trading 100 2
net stable fu nding 273 6 trading 98 100
RCFs see rev olv ing credit facilities retail lending 302 4
recession 81 2 retu rn on assets (ROA) 19
recov ery rate (RR) 134 5 retu rn on capital (ROC) 8, 254 5
regu lation 263 4 retu rn on equ ity (ROE)
see also Basel ru les liqu id asset bu ffer 276
regu latory capital 281 306 liqu idity ratio 157
Basel ru les 283 306 new bu siness m odel 264, 272
capital adequ acy 284 5 operating ex penses 19 20
requ irem ents 282 4 retu rn-to-m atu rity ex pectations
reinv estm ent risk 72 hy pothesis 73, 76
relativ e bond v alu es 70, 86 retu rns
reports/reporting 224 32, 274 6 holding period 74
ALCO 224 32 tim e-w eighted rate of retu rn 88
ALM 183, 224 5, 227 y ield cu rv e 70
BCBS list 274 5 see also retu rn on
concentration report 250 rev erse repos 52 3, 56
fu nding 250 1, 275 rev olv ing credit facilities (RCFs) 311
gap reports 195 6, 217 18 risk
incom e reports 230 2 ALM reporting 183
inter-entity fu nding 251, 275 basis 176 7
interest rate gap 227 8 defau lt 171
liqu idity gap 186 7 gap 176, 247
liqu idity reports 246, 248, 250 2 incom e 174
m anagem ent 226 7 inv estm ent 174
P&L report 14 21 liqu idity gap 186 91
produ ct break dow n report 229 m ark et 4, 17 18
risk retu rn profi le 231 m igration 132
INDEX 355
m itigation 237 sm all bank s 213 14

operational 288 9 m ediu m bank s 215 16
option 177 8 large bank s 216 18
price 174 sim u lation m odelling 218 19
reinv estm ent 72 benefi ts 206 7
repo collateral 61 ex am ples 207 12
ru noff 177 interest rate risk 216 18
VaR m ethodology 5 liqu idity 216
w eighted risk assets 284, 295, policy 212 19
299 300 process 204 6
y ield cu rv e 176 sim u lation m odelling 218 19
see also credit risk ; interest rate segm entation hy pothesis 78 80
risk ; liqu idity risk sell/bu y back 56 60
risk -adju sted ex posu re 285 Bloom berg screen 59 60
risk m anagem ent ex am ples 58 60
ALM policy 212 13 transaction diagram 58
com m on approach 212 13 settlem ent 50 1, 113 15
historical bank m odel 263 short sterling fu tu res 104 5
liqu idity 233 59, 271 6 short-term debt 298 300
see also risk sim ple interest 318, 326
Riskmetrics VaR m ethodology 178 sim u lation m odelling 218 19
risk retu rn 231 Singapore dollars 26 7
ROA see retu rn on assets SIVs see stru ctu red inv estm ent
ROC see retu rn on capital v ehicles
ROE see retu rn on equ ity sm all bank s 213 14
RR see recov ery rate sm all-and-m ediu m -sized
RRRA Bloom berg screen 54 6 enterprises (SMEs) 134, 302
Rubinstein on D erivatives 74 SONIA see sterling ov ernight
Ru binstein, Mark 74 interest rate av erage
ru noff risk 177 sov ereign bu siness
Basel II 289 90, 292 8
secondary m ark ets 31, 120 1 bonds 158 66
secu rities 25, 27 39 calcu lation 293 8
bank er’s acceptances 37 9 ex am ples 292 3, 296 8
Bloom berg BBAM screen 28 IRB approaches 292 8
discou nt basis 25, 34 9 OECD 289, 292 3, 296
eligible bank er’s acceptances see also gov ernm ent bonds
38 9 special pu rpose v ehicles (SPVs)
lending 301 ABCP 43 4, 46
m oney m ark et deposits 27 9 secu ritization 204 5
T-bills 33, 36 7 see also condu its
y ield basis 25, 27 34 specials trading 100 2
see also Treasu ry bills contribu tory factors 100
secu ritization 202 19 ’going special’ 100 1
ABCP 43 4 m atched book 102
ALM policy 212 19 repos 100 2
356 INDEX
specifi c collateral 61 credit interm ediation 98 100

spot rates 75, 92 incom e 4 5, 18
spot sales, see also sell/bu y back s interest rates 96 8, 103 29
spot y ield cu rv e see zero-cou pon m atched book 102 3
y ield cu rv e repos 98 100
SPVs see special pu rpose v ehicles specials 100 2
standards, loan origination 139 41 y ield cu rv e 96 8
standby letters of credit 310 11 trading book 10 13
static gap 150 Basel I 285
sterling ov ernight interest rate Basel III 305 6
av erage (SONIA) 124 credit risk 132
stock collateral see general traditional ALM 182 4, 198 202
collateral blended costs 200 2
stock loans 48 borrow ing costs 200
stresses 242 3, 272 3 capital requ irem ents 183
strip bonds 72 critiqu e 198 202
stru ctu ral liqu idity m anagem ent fu nding costs 199 205
239 fu nding m anagem ent 182 3
stru ctu red deposits 311 gap analy sis 183 4
stru ctu red inv estm ent v ehicles hedging risk 183
(SIVs) 45 interest rate risk 182
su bprim e lending 140 liqu idity m anagem ent 182 3
su m m ary liqu idity report 252 m atu rity gap 198 9
sw aps 48 setting risk lim its 183
see also interest rate sw aps transfer price (TP) 244, 255, 257
sy ndicated loans 312 15 Treasu ry bills (T-bills)
discou nt rate 36 7
T-bills see Treasu ry bills ex am ple 37
tactical liqu idity m anagem ent 239 m oney m ark ets 24, 33
tenor 31, 254 5 price calcu lation 36 7
term loans 311 US dollar m ark et rates 33
term stru ctu re of interest rates 69, Treasu ry fu nction of bank 199 200
84, 171 Tu llett & Tok y o 32 3, 126
tick v alu es 104 5
tim e UBS credit bu siness 255
deposits 27 9, 308 u nbiased ex pectations hy pothesis
liqu idity gap 148 9 73 6
m atu rity bu ck ets 178 u ndated bonds 332
tim e-w eighted rate of retu rn 88 United Kingdom (UK)
v alu e of m oney 323 failed bank s 139
total retu rn sw aps 48 FSA 252, 271 3, 276 7
TP see transfer price gilts 98 100, 162 6, 332
trade bills see bank er’s acceptances NII 15 16
trading 95 141 United States (US)
approach 96100 failed bank s 136
book 10 13, 132, 285, 305 6 federal fu nds 34 5, 126 9
INDEX 357
prim e interest rate 34 y ield cu rv e 67 94

US CP 40 1 analy sis 72 3
WACC ex am ple 202 5 break ev en principle 88 91
see also dollars; Treasu ry bills deriv ativ es pricing 70
ex am ple calcu lations 88 92
v alu ation, MtM 131 3 ex pectations hy pothesis 73 6
v alu e date 50 1 fl at y ield cu rv e 80
v alu e-at-risk (VaR) forw ard rates 88 93
ALM 219 20 fu tu re y ield 70
Riskmetrics 178 im portance 68 9
trading incom e 5, 18 interest rate sw aps 70, 82, 122 3
v anilla interest rate sw aps 117, liqu idity preference theory 76 8
121 2 m easu ring retu rns 70
VaR see v alu e-at-risk
relativ e bond v alu es 70
v ariable rates
risk 176
assets 194 5
segm entation hy pothesis 78 80
liabilities 194 5
setting the y ield 69 70
m ortgages 118 19
v ariation m argin 57, 64 shape 71 3, 75, 77, 79 83, 96 8
v olatility 219 20 theories 73 83
trading 96 8
w eighted av erage cost of capital u sage 69 70
(WACC) 200 5 y ield-to-m atu rity 71 2, 73, 76
w eighted risk assets 284, 295, zero-cou pon 72, 76, 83 8
299 300 y ield-to-m atu rity 71 2, 73, 76
w holesale fu nding 242
w holesale m ark eting 11 13 zero-cou pon bonds 72, 83 4
zero-cou pon y ield cu rv e 72, 76,
y ield 83 8
CDs 30 4 arithm etic 86 8
CP 42 3 discou nt factors 87 8
as qu otation basis 25, 27 34 equ ation com pliance 83 4

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AN INTRODUCTION TO

A John Wiley and Sons, Ltd, Publication

1 BANK BUSINESS AND CAPITAL 1

Bank ing bu sines s 2

2 THE MONEY MARKETS 23

3 THE YIELD CURVE 67

Analysing and interpreting the yield curve 72

4 INTRODUCTION TO TRADING AND HEDGING 95

5 ASSET AND LIABILITY MANAGEMENT I 143

The liquidity ratio 156

6 ASSET AND LIABILITY MANAGEMENT II 167

7 ASSET AND LIABILITY MANAGEMENT III:

8 BANK LIQUIDITY RISK MANAGEMENT 233

9 A SUSTAINABLE BANK BUSINESS MODEL:

10 BANK REGULATORY CAPITAL 281

Appendix A Summary of bank product line 307

In m any w ay s, a handbook that helps to contex tu alize the bank ing

m ark ets are highly dy nam ic and interconnected. Thu s, historical

description, it m arries both science and hu m an intu ition. Hu m an

Bank ing is a long-established and honou rable profession. The

in 2008, after Lehm an Brothers collapsed, and w hich rem ains a

Lay out of the book

a discu s sion of bank strategy and w hy this shou ld focu s on

As alw ay s, the intention is to rem ain accessible and practical

Ack now ledgem ents

Service or function Revenue generated Risk

Fees and com m issions

The fi rst m ethod m ay not generate su ffi cient fu nds, especially if a

SCOPE OF BANKING ACTIVITIES

Figure 1.1 Scope of bank ing activ ities.

Bank ing and trading book s

Table 1.2 Bank analy sis ratios for capital strength

Ratio Calculation Notes

Core capital ratio Tier 1 capital/ A k ey ratio m onitored, in

Source: Higson (1995).

The banking book

FINANCIAL STATEMENTS AND RATIOS

The balance sheet

Profit and loss report

Table 1.3 Com ponents of a bank balance sheet

Cash Short-term liabilities

Table 1.4 Com ponents of bank incom e statem ent, ty pical

Core operating incom e 100

Source: Bank fi nancial statem ents.

engages in large-scale w holesale capital m ark et bu sines s. Inv est-

Net interest income

Figure 1.2 Com position of earnings.

The cost of fu nding is a k ey v ariable in generating ov erall NII. For a

These are referred to as NIBLs (non-interest-bearing liabilities).

liabilities su ch as instant access deposits is far below the w holesale

Fee and commission income

the bank to additional credit or m ark et risk . Fee incom e represents

For ex am ple, a strategy pu rsu ed by bank s in the 1990s w as to m erge w ith

a proportion of rev enu e. A nu m ber of cost/incom e ratios are u sed by

Table 1.5 Bank cost/incom e ratios

Ratio Calculation Notes

Pre-tax ROE Pre-tax incom e/ Measu res the pre-tax retu rn on

Money m ark ets ex ist in ev ery m ark et econom y , w hich is practically

u sers can u se screen DCX to look u p the nu m ber of day s of an

Money m ark et deposits

The term LIBOR or ‘Libor’ com es from London Interbank Offered

The effectiv e rate on a m oney m ark et deposit is the annu al equ iv a-

A su m of £250,000 is deposited for 270 day s, at the end of w hich