Page 60 - Risk Management in current scenario

This example illustrates that the timing and amount of cash fl ows are
important in managing the interest rate risk using fi rst derivative.

The gap between the fi rst derivative of assets and liability reduces by
around Rs1000 Cr when the assets from the fi rst four years were pushed
to 10th to 13th year. On pushing the assets farther than this, the impact
on the gap reduces due to discounting effect (Optimum distance). This
suggests that the realignment of assets based on fi rst derivative of assets
and liability helps in bringing the assets sensitivity nearer to liability
sensitivity. This method would also help in setting purchasing philosophy
of future assets from future increase in reserves.

If Company has surplus assets say Rs.1000 Cr in this example, and can
invest for 13 years would reduce the gap totally.

So in place of duration, first derivative of assets and liability may be used
in addressing the ALM problem.

Challenges with Other Methods
• Other method to manage interest rate risk are performed by
projecting the assets and liability cash fl ows; this method presents
two challenges, one is, it does not provide an “objectivity way” in
measuring level of matching or mismatching between assets and
liability apart from visual realization as there is a no way to quantifi
cation. Also as new business keep pouring in, the method would give
no idea how the efforts of risk management is bearing fruits as the
gap between the assets and liability cash fl ows will keep on
widening. The second challenge is, as the future premium is not yet
received it is impossible to judge the level of assets and liability
matching.
• To calculate the duration of liability as a sensible number; may move
the premium into assets side so that liability cash fl ow are of same
sign. Though this helps in calculating a sensible value of duration of
liability, however as the duration of premium is shorter than the

58 | Risk Management in Current Scenario