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