Asset Liability Management | Risk Factors [Video]

We know that ALM is about properly matching assets and liabilities to manage risk, but what specific risks are faced by a typical bank?

The most significant risk is interest rate risk.

There are several different types of interest rate risk, as discussed below.

Interest rate gap risk occurs when:
(a) there is a mismatch between floating-rate and fixed-rate instruments
(b) the timing of rate-setting for floating-rate instruments is not aligned

Interest rate basis risk occurs when floating-rate assets and floating-rate liabilities are set to different indexes.

Option risk occurs when a counterparty exercises an option that changes the expected cash flows of a financial instrument (terminating a contract early, altering the contract, etc.).
• This is a type of interest rate risk because option risk is closely linked to the interest rate

Prepayment risk occurs when a borrower repays the principal sooner than required, and the bank gets stuck re-lending the money at a less favorable interest rate.
• Prepayment risk is a specific type of option risk and is closely linked to the interest rate
• Prepayment happens when interest rates decline and borrowers decided to refinance

Banks also face risk factors aside from interest rate risks. These include:

Exchange rate risk occurs when exchange rates change and the bank translates foreign currency back into its functional currency (the bank will recognize a gain or a loss).

Price risk occurs when there are changes to the price of investments in a bank’s trading portfolio.

Credit risk occurs when a counterparty defaults (e.g., a borrower fails to pay).

Liquidity risk occurs when the bank is unable to satisfy its obligations without suffering extreme losses when one or more sources of funding suddenly become unavailable.
• A liquidity crisis could be caused by a run on the repo market, an inability to roll over maturing debt, etc.
• Liquidity risk can be severe and cause the bank to become insolvent
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