Duration Gap

The duration Gap is financial term used by the bank to measure their risk due to changes in the interest rates. This is one type of Mismatches that can occur and are also Known as Assets Liability Mismatches

Duration gap is calculated as under

Duration gap = Duration of earning assets-durations of paying liability x Paying Liability /earning

When the duration gap is zero, the firm is immunized only if the size of the liabilities equals the size of the assets. In this example with a two-year loan of one million and a one-year asset of two millions, the firm is still exposed to rollover risk after one year when remaining year of the two year loan has to be financed

0 = 1-2 x 1,000,000 / 2,000,000

assets

Maturity Gap

This is a method for attempting to quantifying interest rate risk by comparing potential changes in the value of the assets and liability that all are affected by the interest rate fluctuation

What will happen to the value or net income for the bank if interest rates go up or down

When the interest rate rises

When the interest rate rises, the value of the longer-lived assets will fall by more the shorter-lived liabilities

If the maturity gap (or duration gap) is positive, the bank manager will want to shorten the maturity gap

And if the repricing gap is negative, the manager will want to move it towards zero or positive

When the interest rate decreases

When the interest rate decreases the manager should reverse these strategies. Changing the maturity, duration, or funding gaps on the balance sheet often involves changing the mix of assets and liabilities

may involve changes in financial strategy for the bank which may not be easy to accomplish. Later in the text, methods of achieving the same results using derivatives will be explored.