Duration gap
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The duration gap is a financial and accounting term for the difference between the duration of assets and liabilities, and is typically used by banks, pension funds, or other financial institutions to measure their risk due to changes in the interest rate. This is one of the mismatches that can occur and are known as asset liability mismatches. Another way to define Duration Gap is : it is the difference in the sensitivity of interest-yielding assets and the sensitivity of liabilities (of the organization ) to a change in market interest rates (yields).
The duration gap measures how well matched are the timings of cash inflows (from assets) and cash outflows (from liabilities).
When the duration of assets is larger than the duration of liabilities, the duration gap is positive. In this situation, if interest rates rise, more assets than liabilities will lose value, thus reducing the value of the firm's equity. If interest rates fall, more assets than liabilities will gain value, thus increasing the value of the firm's equity.
Conversely, when the duration of assets is less than the duration of liabilities, the duration gap is negative. If interest rates rise, more liabilities than assets will lose value, thus increasing the value of the firm's equity. If interest rates fall, more liabilities than assets will gain value, thus reducing the value of the firm's equity.
If there is a zero duration gap, then the firm is immunized against interest rate risk.
Some of the limitations of duration gap management include the following:
- the difficulty in finding assets and liabilities of the same duration
- some assets and liabilities may have patterns of cash flows that are not well defined
- customer prepayments may distort the expected cash flows in duration
- customer defaults may distort the expected cash flows in duration
- convexity can cause problems.
The duration gap = duration of assets - (duration of liabilities)*(total liabiliites/total assets).
Duration has a double-facet view. It can be beneficial or harmful depending on where interest rates are headed.
