Due to the greater uncertainty in the economic environment, financial institutions become
a very difficult task to manage. Interest rates have become much more volatile, resulting in
substantial fluctuations in profits and in the value of assets and liabilities held by financial
institutions. That is why financial institution managers become more concerned about
managing the risk their institutions face as a result of greater interest-rate fluctuations and
defaults by borrowers. In this paper, we focus on financial institutions specifically banks
and examine how managers cope with interest rate risk, and the risk arising from
fluctuations in interest rates. Furthermore, we look at the Duration Gap Analysis, the
Maturity Gap Analysis, and the Repricing Gap Analysis as tools for interest-rate risk
reduction.
Maturity Gap
The time to maturity, or the number of years remaining prior to the final principal
payment, can be a resourceful measure of interest rate risk. All other factors held constant,
the longer the maturity of a bond, the greater the volatility in market value due to a change
in interest rates (Fabozzi, 2003).
The maturity of a portfolio is simply the weighted maturity of all bonds or securities,
which makes it possible to calculate the maturity for total assets as well as total liabilities.
A severe mismatch in the maturity of its assets and liabilities exposes banks to interest rate
risk. For example, a rise in interest rates will reduce the market value of assets and
liabilities, with the reduction being greater for longer maturities. If interest rates rise and a
bank has a positive maturity gap, the bank will face a larger fall in the value of its assets
than its liabilities, reducing its equity or net worth. Thus, the weighted – average maturity
provides useful information on exposures to changes in interest rates.
However, the weighted-average maturity measure is not a perfect measure of interest rate
risk. A bank that matches the maturity of its assets with the maturity of its liabilities may
still be exposed to losses from changes in interest rates. This situation may arise if the
timing of the cash flows on assets and liabilities is different. Although maturity gap
management can help minimize the impact of market interest rates fluctuations on net
interest income, it does not prevent banks from suffering losses related to impairment of
the balance sheet. A change in market interest rates can lead to a reduction in the value of
balance sheet assets greater than liabilities, with the effect of reducing the economic value
