In times, when
internationalization of financial system increases and the pressure of
competition rises, banks will be obligated to find an equilibrium between a
prudent and balanced term structure of assets and liabilities, while pursuing
higher levels of profitability (BCBS, 2010). Due to the increase of volatility
of interest rates in present society, bank managers become more concerned about
the exposure to interest rate risk (Mishkin and Eakins 2009). The interest rate risk is a risk, which can
make a change in the value of an investment. These changes mostly affect
securities inversely and one of the things that can reduce this is investing in
fixed-income securities with different durations. Potential increases in market
interest rates in a risk to the value of fixed-income securities. When market
interest rates increase, prices for previously issued fixed-income securities
as traded in the market drop. Interest rates also affect the price sensitivity,
where prices on securities are more sensitive to increase in market interest
rates, which result in a sharp decline in their security values. To measure interest-rate risk, and fulfill
the function for banks is duration gap analysis, which examines the sensitivity
of the market value of the financial institution’s net worth to changes in
interest rates. Generally, Duration is
a measure of the sensitivity of the price -the value of principal – of a
fixed-income investment to a change in interest rates. (Investopedia).
According to Investopedia, the duration is expressed as a number of years.
Accordingly, a rise in interest rates can indicate the bond prices to fall,
while declining interest rates indicate bond prices to rise.
Duration as a concept is very useful for
banks and company’s even though it is a very complicated concept. A benefit of
using a duration analysis is that it provides a single number, which tells the
bank their overall exposure to interest rate risk. Duration is a measurement that can be used
for the project to indicate when the total of the project value will be
captured, it also captures both the time value of money and the whole of the
cash flows of a project. Projects with
higher durations carry more risk than projects with lower
durations(Kaplan). According to Mishkin,
the Duration is a useful concept, because it provides a good approximation,
examines the sensitivity of the market value of the financial institution’s net
worth to changes in interest rates using the following formula :
After calculating the
duration for each assets and liabilities on the bank’s balance sheet, the
manager of the bank could use this formula in order to calculate the changes of
the market value of each asset and liability where there is a change in interest
rates and then it can calculate the effect of net worth.As was mention duration
gap analysis analyze the sensitivity of the market value of the financial
institution’s net worth to changes in interest rates.There is another way to
find the answer by calculating the duration gap
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