Maturity Gap Analysis and Duration Gap Analysis

Maturity Gap Analysis

The simplest analytical techniques for calculation of IRR exposure begins with maturity Gap analysis that distributes interest rate sensitive assets, liabilities and off-balance sheet positions into a certain number of pre-defined time-bands according to their maturity (fixed rate) or time remaining for their next repricing (floating rate). Those assets and liabilities lacking definite repricing intervals (savings bank, cash credit, overdraft, loans, export finance, refinance from RBI etc.) or actual maturities vary from contractual maturities (embedded option in bonds with put/call options, loans, cash credit/overdraft, time deposits, etc.) are assigned time-bands according to the judgement, empirical studies and past experience of banks.

A number of time bands can be used while constructing a gap report. Generally, most of the banks focus their attention on near-term periods, viz. monthly, quarterly, half-yearly or one year. It is very difficult to take a view on interest rate movements beyond a year. Banks with large exposures in the short-term should test the sensitivity of their assets and liabilities even at shorter intervals like overnight, 1-7 days, 8-1 4 days etc.

In order to evaluate the earnings exposure, interest Rate Sensitive Assets (RSAs) in each time band are netted with the interest Rate Sensitive Liabilities (RSLs) to produce a repricing ‘Gap’ for that time band.

The positive Gap indicates that banks have more RSAs than RSLs. A positive or assets sensitive Gap means that an increase in market interest rates could cause an increase in NII.

Conversely, a negative or liability sensitive Gap implies that the banks NII could decline as a result of increase in market interest rates. The negative gap indicates that banks have more RSLs than RSAs. Gap is the difference between a bank’s assets and liabilities maturing or subject to repricing over a designated period of time.

The Gap is used as a measure of interest rate sensitivity. The Positive or Negative Gap is multiplied by the assumed interest rate changes to derive the Earnings at Risk (EaR). The EaR method facilitates to estimate how much the earnings might be impacted by an adverse movement in interest rates. The changes in interest could be estimated on the basis of past trends, forecasting of interest rates, etc. the banks should fix EaR which could be based on last/current year’s income and a trigger point at which the line management should adopt on-or off-balance sheet hedging strategies may be clearly defined.

The Gap calculations can be augmented by information on the average coupon on assets and liabilities in each time band and the same could be used to calculate estimates of the level of NII from positions maturing or due for repricing within a given time-band, which would then provide a scale to assess the changes in income implied by the gap analysis.

In case banks could realistically estimate the magnitude of changes in market interest rates of various assets and liabilities (basic risk) and their past behavioural pattern (embedded option risk), they could standardize the gap by multiplying the individual assets and liabilities by how much they will change for a given change in interest rate. Thus, one or several assumptions of standardized gap seem more consistent with real world than the simple gap method. With the Adjusted Gap, banks could realistically estimate the Earnings at Risk (EaR).

Duration Gap Analysis

Duration is a measure of change in the value of the portfolio due to change in interest rates. Duration of an asset or a liability is computed by calculating the weighted average value of all the cash-flows that it will produce with each cash-flow weighted by the time at which it occurs. It is expressed in time periods. Duration of high coupon bond is always shorter than duration of low coupon bonds because of larger cash inflow from higher interest payments. With zero coupon bonds, the duration would be equal to maturity. By calculating the duration of the entire asset and liability portfolio, the duration gap can be calculated, that is, the mismatch in asset and liability duration and, if necessary, corrective action may be taken to create a duration match.

Measuring the duration Gap is more complex than the simple gap model. The attraction of duration analysis is that it provides a comprehensive measure of IRR for the total portfolio. The duration analysis also recognizes the time value of money. Duration measure is addictive so that banks can match total assets and liabilities rather than matching individual accounts. However, Duration Gap analysis assumes parallel shifts in yield curve. For this reason, it fails to recognize basis risk.

About Abey Francis

Abey Francis is the founder of MBAKnol - A Blog about Management Theories and Practices - and he's always happy to share his passion for innovative management practices. You can found him on Google+ and Facebook. If you’d like to reach him, send him an email to: [email protected]
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