Is duration GAP a valid tool to manage the interest rate risk? WHY?

Expert Solution

Duration Gap Analysis
Duration Gap examines the sensitivity of the market value of a financial institution's balance sheet or assets & liabilities to changes in the interest rates. It is a tool that is used to measure interest rate risk.
Macaulay's duration is the basis for duration gap analysis

Duration Gap Formula
= DurationA* [Change in Interest RateA / (1 + Old Interest RateA)] - {DurationL * [Change in Interest RateL / (1 + Old Interest RateL)] * Market Value of Liabilties/ Market Value of Assets}

If the duration gap is positive and the interest rate decrease, then the total market value of assets will increase more than the total market value of liabilities, and thus, it will result in more net assets.
And if the interest rate increases, then the total market value of liabilities will increase more than the total market value of assets, and thus, it will create more net liabilities

If the duration gap is negative and the interest rate increases, then the total market value of assets will increase more than the total market value of liabilities, and thus, it will result in more net assets.
And if the Interest Rate decreases, then the total market value of liabilities will increase more than the total market value of assets, and thus, it will create more net liabilities

It is when the duration gap is zero, then the market value of assets and liabilities will change at the same pace and thus results in no net assets of liabilities.

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