Offering ALMs on... Lost in Translation

Issue 1

Loans, interest rates, debt, mortgages, cash flows, current holdings, scenario generation, liabilities…  STOP!  Too much information.  

In the good ol’ days managing your wealth was not so technical; people were exposed to it as a part of regular life. They grew up learning the ALM language having to handle their farms, animals, families and the likes. Needless to say, we are all exposed to a certain degree of ALM expertise in our everyday life (Credit to all our lovely stay-at-home mothers and fathers; managing a home and family is not a layman’s job!)

But with the ever-changing laws, increasing expertise, numerous options and resources available to us, our inherent ability to manage does not cover all aspects of our financial needs. Life has moved on from being just about crops and cows, causing the ALM language to widen, too.

Formalizing a proper description of ALM…

On the positive side of it, we have assets. To plainly describe this, it is a resource in your possession that will ultimately give you some benefit and in most cases is generally monetary. These resources come in various different forms like property, stocks, bond, gold and so on.

On the negative side - often characterized by the fact that we are all closet shopaholics to a certain extent - we have liabilities. This is exactly the opposite of assets; resources that need to be paid off such as loans, debts, mortgages, taxes.

Finally, asset-liability management tries to find a perfect balance between the two such that your assets ultimately exceed your liabilities; hence it is also known as surplus management. ALM must take into account the amount of risk you are willing to take since your assets can be invested in high risk resources as they generally have a higher return in the future.

Apart from the fact that you need thorough methods of managing your assets, why is this high level of professionalism so important?

The answer was taken care of more than 2300 years ago by Socrates in Oeconomicus written by Xenophon, his follower. In a conversation between Socrates and Critobulus on wealth management, Socrates asks whether a flute in one’s possession can be considered an asset. Critobulus smartly replies back that it is only valuable if one knows how to play it and for the unskilled, it can be sold to make it profitable. But Socrates argues back by saying,

“And I understand you to concur in the truth of our proposition so far: wealth is that, and that only, whereby a man may be benefited. Obviously, if a man used his money to buy himself a mistress, to the grave detriment of his body and soul and whole estate, how is that particular money going to benefit him now? What good will he extract from it?” (Oeconomicus by Xenophon translated by H. G. Dakyns)

This is exactly how we understand an asset to be described, a resource that benefits you in some way, and Socrates suggests that an asset can become a liability (in this case bad health may lead to medical expenses) unless one knows exactly how to manage the asset for a positive benefit. An ALM precisely manages your assets in a manner that benefits you not just by putting extra money in your wallet.

ALMs do not only cater to individuals but also institutions such companies, organizations etc. There are also numerous amounts of algorithms for different sectors such as pension, insurance and banking, neatly summarized in the ALM Handbook which can be found at http://www.optirisk-systems.com/publications/ALM_Handbook.asp. Optirisk Systems itself is in the progress of creating one such software: LDIOpt (Liability Driven Investment Optimization). The ALM models, created by Schwaiger et al. (2010, Journal of Asset Management), are detailed to manage pension funds.

For further information, there are also three workshops available: Practical Asset and Liability Management Workshop (http://www.optirisk-systems.com/events/practicalalm.asp), Asset and Liability Management Hands-On Workshop (http://www.optirisk-systems.com/events/almws.asp) and Bank Asset & Liability Management (http://www.optirisk-systems.com/events/bankalm.asp).

Comments

[Madhur Murarka]

Good, simple, but reads more like an advertorial.

Would you not like give a few examples to explain the concept?