A Bond Manager's Method for ALM

Over the past few years, many worthwhile efforts have been made to extend the concepts of asset liablity matching analysis beyond simple duration and convexty. Although these have moved us in the right direction, the methods developed to date generally revolve around spot rates and require fairly laborious calculations. This paper describes a very simple methor of analyzing the impact of a change in interest rate levels on the present value of a stream of cash flows. The method described will be referred to throughout the paper as the "bond manager's method". It has the following features: 1. A stream of cash flows can be represented by a "notional" portfolio of "benchmark" bonds with approximately the same sensitivity to changes in interest rate levels as the cash flow stream itself. 2. The amount of each benchmark bond in the notional portfolio can be easily determined using a simple algorithm. These amounts are referred to as "benchmark weights" 3. The impact of a change in interest rate levels on the present value of a stream of cash fows can easily be approximated by multiplying the price changes on the benchmark bonds by the benchmark weights and summing the results. 4. The calculation of spot rates required by most traditional methods of analysis is not re-quired. 5. In practical situations, the method produces results which are not materially different from those produced by more complex methods using spot rates. It is hoped that the simplicity of this method will allow all parties involved in the asset liability risk management process to develop a better feel for the the risks involved ultimately leading to more informed decision-making. The paper deliberately avoids long complex mathematical derivations. Instead, concepts are illustrated using simple examples. It is hoped that this approach will be easier for the average practitioner to follow