The Principles of Banking

Chapter 8

Asset–Liability Management III: Trading and Hedging Principles

In this chapter we introduce trading and hedging as employed by an ALM desk. Our purpose here is to acquaint the practitioner with the essential principles. The ALM and money markets desk supports the banking, fixed-interest and equities desks, hedging new issues, and working with the swaps and options desks. In some banks and securities houses it will be placed within the Treasury or money markets areas, whereas other firms will organise it as an entirely separate function. Wherever it is organised, the need for clear and constant communication between the ALM desk and other operating areas of the bank is paramount.

We look at specific uses of money market products (deposits and repo) in the context of conventional yield curve economics, and the principles of hedging using derivatives.

Trading Approach

The Yield Curve and Interest Rate Expectations

When the yield curve is positively sloped, the conventional banking approach is to fund the book at the short end of the curve and lend at the long end. This is almost a definition of banking and is known as maturity transformation. In essence therefore if the yield curve resembled that shown in Figure 8.1 a bank would borrow, for example, 1-week funds while simultaneously lending out at, say, the 3-month maturity. This is known as funding short. The bank then continuously rolls over its funding at 1-week intervals for the 3-month period. This is known as creating ...