Duration gap is the difference between assets and liabilities held by a financial entity, with the goal of operating with as narrow a gap as possible. Interest rates and economic changes impact the duration gap, and balancing assets and liabilities can be difficult.
A duration gap is a term used to describe the difference or gap that exists between the assets and liabilities held by a financial or commercial entity. One of the most common examples of this type of gap has to do with the difference between the cash inflow in a given period compared to the cash outflow to cover outstanding debts. The general idea is to assess the impact of changes in interest rates and other factors over a specified period of time or duration that affect the value of those assets and liabilities, with those changes either narrowing or widening the duration gap.
The goal in most cases is to operate with as narrow a gap as possible. Sometimes the assessment may show that the duration of the assets is considerably longer than the duration of the liabilities. When this is the case, the company is considered to be in an enviable financial position, as this situation indicates that more assets are coming in than cash is going out. Similarly, if the gap is wider, that indicates that the cash inflow is barely covering the outflow or may even be insufficient to meet obligations in a timely manner, requiring the company to borrow funds or liquidate an asset to cover the deficit.
Determining the duration gap will often require paying close attention to the rise and fall of interest rates, and the impact those changes have on the company’s assets and liabilities. Institutions like banks rely heavily on interest rate activity to generate income. If interest rates fall, this means that the income stream will decrease, even though liabilities remain at the same levels. When interest rates rise, there is a good chance that the income stream will increase, helping to reduce the duration gap between assets and liabilities over a given period of time.
Balancing assets and liabilities to avoid a potential liability mismatch and maintain a more or less stable gap can be difficult. Also, some assets will be more susceptible to changes in interest rates and the economy in general than others, something that may or may not be easily forecast. Even factors such as prepayments from customers can complicate the process of determining the duration gap to some degree, as this effectively adds cash flow to a current period but removes anticipated cash flow from a later period. For these reasons, many institutions constantly reassess the duration gap as a means of assessing the stability of their current financial situations.
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