Definition

The difference between the duration

Bond duration

In finance, the duration of a financial asset that consists of fixed cash flows, for example a bond, is the weighted average of the times until those fixed cash flows are received....

 of asset

Asset

In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...

s and liabilities

Liability (financial accounting)

In financial accounting, a liability is defined as an obligation of an entity arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future.A liability is defined by the...

 held by a financial entity.

Overview

The duration gap is a financial and accounting term 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 mismatch

Asset liability mismatch

In finance, an asset–liability mismatch occurs when the financial terms of an institution's assets and liabilities do not correspond. Several types of mismatches are possible....

es.

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

Cash flow

Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...

 (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

Interest

Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....

 rise, assets will lose more value than liabilities, thus reducing the value of the firm's equity. If interest rates fall, assets will gain more value than liabilities, 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, liabilities will lose more value than assets, thus increasing the value of the firm's equity. If interest rates fall, liabilities will gain more value than assets, thus reducing the value of the firm's equity.

By duration matching, that is creating a zero duration gap, the firm becomes immunized

Immunization (finance)

In finance, interest rate immunization is a strategy that ensures that a change in interest rates will not affect the value of a portfolio. Similarly, immunization can be used to ensure that the value of a pension fund's or a firm's assets will increase or decrease in exactly the opposite amount...

 against interest rate risk

Interest rate risk

Interest rate risk is the risk borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa...

. Duration has a double-facet view. It can be beneficial or harmful depending on where interest rates are headed.

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.

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 refinancing risk

Refinancing risk

In banking and finance, refinancing risk is the possibility that a borrower cannot refinance by borrowing to repay existing debt. Many types of commercial lending incorporate balloon payments at the point of final maturity; often, the intention or assumption is that the borrower will take out a new...

 after one year when the remaining year of the two-year loan has to be financed.

Torque analogy

The duration gap calculation resemble a mechanical torque calculation but with moment arm and force replaced with average duration and total value respectively. It's like the children's seesaw

Seesaw

A seesaw is a long, narrow board pivoted in the middle so that, as one end goes up, the other goes down.-Mechanics:Mechanically a seesaw is a lever and fulcrum....

 lever

Lever

In physics, a lever is a rigid object that is used with an appropriate fulcrum or pivot point to either multiply the mechanical force that can be applied to another object or resistance force , or multiply the distance and speed at which the opposite end of the rigid object travels.This leverage...

 with assets on the left part of the plank and liabilities on the right part. When the plank is balancing horizontally the time-value torque is zero meaning that the maturity of assets and liabilities are matched.



To be able to compare firms and banks of different size the equation has to be normalized by dividing everything by total assets giving the formula for the duration gap.

See also

• List of finance topics
• Bond convexity
  Bond convexity
  In finance, convexity is a measure of the sensitivity of the duration of a bond to changes in interest rates, the second derivative of the price of the bond with respect to interest rates . In general, the higher the convexity, the more sensitive the bond price is to decreasing interest rates and...
  
  
• The duration difference is also shown by sorting into maturity buckes as in the table How the example bank manages its liquidity