What is Duration Gap Analysis? How is it related to stress testing?
When interest rates change, the market value of a bank’s assets and liabilities changes too — but not always by the same amount. Duration Gap Analysis helps measure this difference and understand the risk it creates for the bank’s net worth.
What is Duration?
Duration is the weighted average maturity of a promised stream of future cash flows. It is a value and time weighted measure of maturity that considers the timing of all cash inflows from earning assets and all cash outflows associated with liabilities. Duration measures the average time required to recover the funds committed to an investment.
The calculation of duration depends on three factors: the final maturity of the financial instrument, the size and timing of cash flows (coupon payments), and the yield to maturity (YTM).
What is Duration Gap?
The duration model evaluates the overall interest rate exposure for an FI by measuring the duration gap on its balance sheet. To estimate the overall duration gap, we first determine the duration of the FI’s asset portfolio (DA) and the duration of its liability portfolio (DL).
Positive Duration Gap:
Assets have a longer duration than liabilities. Net worth decreases when interest rates rise. Net worth increases when rates fall.
Negative Duration Gap:
Liabilities have a longer duration than assets. Net worth increases when interest rates rise. Net worth decreases when rates fall.
Zero Duration Gap:
Interest rate fluctuation does not affect net worth.
Practical Example:
Suppose DA = 5 years, DL = 3 years, Assets (A) = Tk. 100 million, Liabilities (L) = Tk. 90 million, initial equity = Tk. 10 million. Interest rates are expected to rise by 1% from 10% to 11%.
The potential loss to equity holders’ net worth: ΔE = [-5 × (0.01/1.10) × 100] – [-3 × (0.01/1.10) × 90] = – 2.09 million. This means the net worth will be reduced by Tk. 2.09 million — about 21% of its initial net worth.
How Duration Gap Analysis is Related to Stress Testing:
Duration Gap Analysis is the foundation of interest rate stress testing. Banks and FIs are required to:
- Estimate the market value of all on-balance sheet rate-sensitive assets and liabilities to arrive at market value of equity.
- Calculate the durations of each class of asset and liability. Arrive at the aggregate weighted average duration of assets and liabilities.
- Calculate duration GAP by subtracting aggregate duration of liabilities from that of assets.
- Estimate the changes in the economic value of equity due to changes in interest rates along three interest rate changes — 1%, 2%, and 3%.
- Calculate surplus or deficit on off-balance sheet items under the assumption of three different interest rate changes.
- Estimate the impact of the net change in the market value of equity on the Capital to Risk-weighted Asset Ratio (CRAR).
