Duration gap
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The duration gap is a financial and accounting term for the difference between the duration of assets and liabilities, and is typically used by banks, pension funds, or other financial institutions to measure their risk due to changes in the interest rate. This is one of the mismatches that can occur and are known as asset liability mismatches. Another way to define Duration Gap is : it is the difference in the sensitivity of interest-yielding assets and the sensitivity of liabilities (of the organization ) to a change in market interest rates (yields).
The duration gap measures how well matched are the timings of cash inflows (from assets) and cash outflows (from liabilities).
When the duration of assets is larger than the duration of liabilities, the duration gap is positive, meaning that the institution will benefit from falling interest rates and be hurt by rising interest rates. If interest rates go up, then the price of assets fall more than the price of liabilities. Conversely, when the duration of assets is less than the duration of liabilities, the duration gap is negative; if interest rates fall, then the price of assets goes up less than the price of liabilities.
Duration has a double-facet view. It can be beneficial or harmful depending on where interest rates are headed.
