Investment and Asset-Liability Management
Investment and Asset-Liability Management
This domain tests how assets are selected and managed to meet liability cash flows, capital needs and risk appetite.
Core rules and concepts
- ALM matches asset cash flows, duration, currency and liquidity with liabilities.
- Duration matching immunizes small parallel yield changes; convexity and cash-flow timing matter for larger or non-parallel moves.
- Strategic asset allocation sets long-term mix; tactical allocation adjusts within limits.
- Credit risk, liquidity risk and concentration risk must be monitored alongside market risk.
- Pension schemes and life insurers with long-tailed liabilities usually hold more bonds; GI insurers need liquid assets for claims.
Worked example
Liabilities have duration 8 years and present value INR 500 crore. Assets have duration 5 years. To reduce the duration gap, the manager can buy longer-dated bonds or receive-fixed swaps. A 100 bp fall in yields raises liability value by about 8% and asset value by about 5%, leaving a funding gap. The manager should also check cash-flow timing and convexity, not just duration.
Traps
Matching duration but ignoring cash-flow timing, assuming all bonds are liquid, and ignoring credit spread duration. Also treating derivatives as off-balance-sheet risk-free hedges.