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Dynamic ALM: Leading financial institutions understand that simply using a static value effect approach to managing risk is only part of the picture. To make better decisions, you need better analysis. Dynamic ALM gives you the power to fully quantify potential impacts of interest rate and exchange rate fluctuations on future earnings and cash flow streams. The dynamic ALM approach intends to optimise not only the asset allocation, but also the management rules at the same time. The result is not merely a recommendation for the ideal asset allocation, but also for the design of the rule system. The following example is to clarify this approach. A pension fund intends to optimize its asset allocation with the help of an ALM study. Besides optimisation criteria (eg, performance, build-up of reserves, etc) the passing of a stress test is crucial. The stress test allows for an examination of the extent to which the assets can cover the liabilities of the pension fund even under different extreme market conditions. Value deductions are made especially for the highly market sensitive asset classes (eg, equities). These investments, which are called risk assets, influence the passing of the stress test to the largest extent. The stress test is only passed, if the reduced assets are still sufficient for covering the liabilities. In the example study, the assets of the pension fund should therefore be aligned in such a way that the risk assets are maximally allocated with a proportion that still allows for passing the test at the end of any future business year, but at the same time at least to an extent for still having perceivable influence on the overall return. A fixed proportion of risk assets can hardly meet the goal of an annual passing of the stress test. Market price variations will inevitably occur over time. The total assets will be reduced due to falling prices and the coverage

of the liabilities could be endangered. As a consequence, a strict adherence to a fixed strategic asset allocation is not possible if the test is not passed. This is taken care of through the dynamisation of the ALM projection method. For this purpose, a reduction of risk assets due to a failure to pass the test is considered as a dynamic management rule. In a further step, the dynamic management rule can be extended in such a way that the strategic risk asset quota is not only reduced and restored path-dependently, but is rendered dynamic itself. The current assets, liabilities and the liability forecast for each year lead to the respective available risk budget from which the maximum proportion of risk assets can be deduced. The purpose of the ALM analysis is therefore besides the effects of a dynamic risk asset quota to identify which proportion of the risk budget should be spent in a business year 100%, or would 80% or even 60% be more reasonable for ideal results? The example illustrates a possible increase of the risk quota in year one, which is lowered again in the following years. At the same time, the results have proved that a complete usage of the risk budget increases the probability of passing the test in contrast to a static adherence to the strategic asset allocation. Compared with a lesser usage of the respective risk budget, however, it does not seem ideal. Yet too little usage of the risk budget is not ideal either, because it leads to a reduction of the target achievement probability in the long run without further decreasing the capital investment risks in return. The analyses are based on different underlying target allocations that differ in their proportions of non-risky assets and are modified through a dynamic risk asset quota. A dynamisation also leads to differences between the individual basic allocations. Some basic allocations prove to be more advantageous when modifying the degree of risk budget usage. Thus, they

can generate a higher added value than other allocations when rendered dynamic. A comparison of the crucial key figures for different target allocations that are subdued to modified dynamic management rules allow for the identification of the ideal allocation and management rule pairs. Overall, the analysis technique allows for a profound insight into the effects of a dynamisation of capital investments and risk budget parameters on the target parameters of the pension fund. Besides the ideal allocation an ideal management rule can also be defined with its help. Together, they allow the requirements concerning the asset side induced by the liabilities to be met.

2. Dynamic ALM delivers: Scenario-dependent projections of future earnings, balance, market values, yields, cash-flows, etc. Ability to measure earnings effects, future liquidity risk, and productinherent optionality risk Powerful new business simulation with user defined volume projections, instrument characteristics, price rate models, and maturity schedules Ability to capture customer behavior: product shift simulations and multifactor prepayment modeling Intuitive user interface with object orientated scenario modeling Stochastic rate scenarios using different term structure models earnings at risk 3. Funds transfer pricing Funds transfer pricing (FTP) is a process used in banking to measure the performance of different business units of a bank. A bank could have different kinds of business units. Most important units are deposit-raising units and funds-advancing units. The former borrows funds from surplus units while the latter lends the same funds to deficit units. Both borrowing and lending contributes to the performance of the bank as a whole. FTP is a mechanism to measure the relative contributions to the bank's profitability and hence shareholder's value. An intermediary is created within the organization usually treasury or central office. All the fund-raising units raise funds from the market at a particular rate and lend the same to the central office at a higher rate. All the lending units borrow the funds from the central office at a particular rate and lend the same to the borrowers at a higher rate. The central office rate is notional in nature and is aligned to market conditions. Thus, for all the units there are two rates available to measure the performance. For a deposit-raising unit the difference between interest paid

to the deposit-holders and interest receivable from central office is the contribution to the bank's profitability. For a lending division the difference between Interest payable to central office and the interest received from the borrowers is the contribution to the bank's performance. To guage FTP, banks can first establish a FTP curve. A general curve is calculated by plotting the relationship between yield to maturity and time to maturity, then adjusted to reflect the lending needs of each location. A rate is then assigned to each of the transactions that occur at the bank. For example, a five-year bond would have a different rate than a 10-year bond. Finally, all of the rates are entered into the FTP system.