Risk and Asset Liability Management
Throughout this book we have switched more or less freely in our discussion between traditional investment banks and development institutions. In a development institution (or a small financial institution) the financial activities carried out by the treasury amount to the near totality of all the financial activity of the institution since the remaining ones are fairly basic. In a traditional investment bank the treasury desk is just one of many. As far as risk is concerned we need to introduce the subject with a qualifier as to which type of institution we will be mainly focusing on. Throughout this book we have been focusing on debt (bonds) and loans, and it is the relation between the two that we will be focusing on now: the managing of this relation and the risk involved is defined as asset liability management, as we have mentioned in Section 1.4.
We will begin by discussing leverage and in particular how much of the lending activity is funded by debt; we shall then digress a little with an introduction to hedging and risk neutrality in order to explain what it means when bonds are hedged dynamically or statically. An important section, the core of asset liability management, on the types of funding risks follows; it will be supported by two numerical sections in which we explain these concepts through examples.
A traditional financial institution would face and manage risks (currency, credit, etc.) that in their complexity are ...