Good Essay On Asset /Liability Management
Peer or alpha risk assumes that the portfolio is sufficient in its diversification and elimination of unsystematic risk during performance measurement. Since alpha is a representative of a performance portfolio that is about a benchmark, it represents the values that portfolio managers add or subtract from the return of funds. That is alpha represents the ROI that is not the consequence of the general movement in the market. Therefore, the alpha risk of zero (0) indicates that the portfolio is tracked perfectly with the index of the benchmark, and the manager has no loss or addition of any value. The alpha risk originated during the advent of the weighted index such as S&P 500 for the stock markets. Consequently, the risk attempts to emulate the performance of a portfolio that covers the whole market. Therefore, it gives each investment area a proportional weight. In addition, the investors can hold their respective portfolio managers to higher standard levels for producing better returns.
Any asset has a degree of a risk. Therefore, asset risk or beta risk is the asset that has a significant volatility of price degrees such as equities, real estate, bonds of high yields, and other commodities. For instance, in the banking sector, asset risk is the asset that is owned by the bank of which may have a fluctuating value, especially due to changes in interest rates, quality of the credits, and repayment risks. However, it may also refer to the capital of equity in a company that is under receivership since the claims of the shareholders of such companies will be ranked below those of the bondholders and lenders of the company.
Regarding the asset risk, investors should focus on the preservation of the capital in securities and the fund portfolios that has low betas. In contrary, the investors that would wish to take more risks in favor of more returns should focus on high beta investments.
Asset Liability Management risk
Asset liability risk (ALM) occurs when the assets of any company underperform than its liabilities. The asset liability management involves the management of all assets and cash inflows to fulfil the financial obligation of the company. Asset management risk is where one may endeavor to mitigate the hazards of failing to fulfil the asset- liability obligations in the company and the success of the process will make the organization more profitable.
Some financial experts prefer the application of surplus optimization for a better explanation to maximize the available assets to meet the complex liabilities that are in constant increase. However, the surplus is the difference between the market value of the assets and the current value of liabilities and their interrelationship.
The perspective of the discipline is conducted on a long-term basis, and the risk that arises from the asset- liability interaction is more strategic than tactical. For instance, a mortgage is the most common liability that people do fund from their cash inflow whereby every month they mortgage customers has to face the task of sufficient assets to repay the mortgage. Another example is the pension plan that must satisfy the contractual benefits to the retirees. At the same time, pension plans should sustain the asset base through careful allocation of assets and risk monitoring to generate the ongoing payments. The asset- liability management risk has become a complex work and the understanding of both internal and external factors that carries this aspect of risk is essential to a suitable solution. However, careful allocation of assets do not account only for the growth of the assets but also addresses the nature of liabilities in an organization.
Investors may expose themselves to risk. For instance, when focusing on the reduction of risk among the underperforming peers, investors should take a considerable asset risk that is larger than the ALM risk. Similarly, the investors that are seeking for the above risks will have a vast range to operate. Therefore, they will find solutions that will operate better than the available solutions within the single- risk space.
Investors will always focus on the absolute investment returns, though with little concern for the investment risks. The three types of risks discussed in this article can offer some balance to the equation of risk return. The measurement of these risks will enable investors to keep in mind that risk is just a common factor that they should consider since it can affect the quality of their investments. The main focus of the consultants and investment committees is to outpace the liabilities to produce better returns. According to the article, the impact of the accounting smoothing is that it created a low reported earnings by eighty percent.
The article also highlights the impact of the long term pension plan as a smaller portion of the liability due to longer discounting periods. Hence, the more sensitive it becomes with a change in interest rates. According to Arnott, the volatility of the pension plan will lead to a fall in the cash flow as the fall interest rates will lead to the rise in the present value (Arnott, 2004). The article also articulates that the tolerating more peer risk will create room for a substantial reduction in liability risks. Similarly, the pension plans should have a modest commitment to long-term bonds because the approach will lead to less risk to the plan.
Arnott, R. (2004). Can We Keep Our Promises? Financial Analyst Journal.