With the earning gap, we saw that changes in interest rates could affect the bank’s profit. But changes in interest rates can also affect the value of the bank’s equity. This is because changes in interest rates:
• Affect floating-rate and fixed-rate instruments in different ways, with the value of fixed-rate instruments usually being more sensitive to changes in interest rates
• Affect long-term and short-term instruments in different ways, with the value of long-term instruments usually being more sensitive to changes in interest rates
A bank can measure the sensitivity of a financial instrument by calculating its duration. The bank can then try to minimize the duration gap, which is the difference between the duration of the bank’s financial assets and the duration of the bank’s financial liabilities. Reducing the duration gap will mitigate the effect of changing interest rates on the value of the bank.
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