Question

Many banks have a duration mismatch between their assets and their liabilities. Explain why this duration mismatch arises and how swaps can be used to manage the interest rate risk caused by this duration mismatch.

Answer 1

NIM: Net interest margin

NIM = yields on assets - cost of liabilities

As the duration of assets increases, the yields on assets increases. That is banks charge higher interest rates on longer-maturity loans

As the duration of liabilities decreases, the cost of liabilities decreases. That is banks borrow for shorter terms and keep revolving the debt as to decrease the cost of financing

Thus banks always want to increase the duration of assets (tenure of loans passed) & decrease the duration of liabilities (tenure of borrowing)

This results in an ALM (asset-liability management) mismatch and results in a large positive duration gap

The use of swaps:

Since the duration gap is positive, if the interest rates rise the banks will have mark to market losses & if the interest rates fall, the banks will have a mark to market gain

If interest rates rise are expected to rise,

Then bank will enter into a swap to receive floating & pay fixed. The positive payoff from swap is used to offset mark to market losses