INTEREST RATE GAPS

The Gap concept has a central place in ALM for two reasons:
(i) It is the simplest measure of exposure to interest rate
risk.
(ii) It is the simplest model relating interest rate changes to
interest income.
The interest rate gap is a standard measure of exposure to
interest rate risk. There are two types of gaps:
(i) The fixed interest rate gap for a given period: the
difference between fixed rate assets and fixed rate
liabilities. For fixed rate assets and fixed rate liabilities,
the interest rate remains fixed during the reference
period.
(ii) The variable interest rate gap: the difference between
interest sensitive assets and interest sensitive liabilities.
There are as many variable interest rate gaps as there are
variable rates (1 month LIBOR, 1 year LIBOR etc.)

Both the differences are identical in absolute value when

total assets are equal to total liabilities. However,
whenever there is a liquidity gap, they differ by the
amount of liquidity gap.
Horizons need to be specified for calculating interest rate
gaps. Otherwise, it is not possible to determine which rate
is variable and which rate remains fixed between today and
the horizon. The larger the horizon, the larger the volume
of interest sensitive assets and liabilities because longer
periods allow more interest rate resets than shorter periods.

An alternative view of the interest rate gap is the gap

between average reset dates of assets and liabilities.
However, this is a crude measure of interest rate risk.
E xam p le:

Fix ed R ate Liabilities200 Fixed R ate A ssets 400

V ariable R ate Liabilities 800 V ariable R ate A ssets 600
------ -------
1000 1000
------ ------
Fix ed interest rate gap +200
V ariable interest rate gap-200
Fix ed interest rate gap- V=ariable interest rate gap
Interest Rate Gap and Variation of Interest Margin
The interest rate gap is the sensitivity of interest income
when interest rate changes.
∆ IM = (VRA –VRL) ∆ I
= Interest rate gap x ∆ I
The above formula is an approximation because there is no
such thing as a single interest rate. It however applies
when there is a parallel shift of all interest rates or when
the variable interest rate gap relates to a specific market
rate.
A major implication of hedging interest rate risk is the
making of interest margin ‘immune’ to interest rate
changes. It simply implies neutralizing the gap.
If VRA =300 VRL = 200 and the interest rate changes from
10% to 11%, the variation in interest margin will be (300-
200) x 0.01 = +1

Over a multi period horizon, sub-period calculations are

necessary when interest rates rise, the cost increase
depends on the date of rate reset.
Example
End of Period Month 1 Month 2 Month 3
Variable Rate Assets 0 250 300
Variable Rate Liabilities 200 200 200
------ ------- -------
Cumulative gap -200 + 50 +100
Marginal gap -200 + 250 + 50
Monthly Changes in Interest Margin
Month Cumulative Gap Monthly Variation of Interest
Margin
1 -200 (-200 x 1% x 1/12) = -1/6
2 + 50 ( 50 x 1% x 1/12) = 1/24
3 +100 (100 x 1% x 1/12) = 1/12
------
-1/24
• The variation can also be calculated using the marginal
gaps:

[ (-200 x3)+(250x2) + (50x1)] x 1% x 1/12

= (-600 +500 +50) x 1% x1/12
= -1/24
Interest Rate Gaps and Liquidity Gaps
The interest rate gap is similar to the liquidity gap except
that it isolates fixed rate from variable rate assets and
liabilities. Another difference is that any interest rate gap
requires us to define a period because of the fixed rate-
variable rate distinction. Liquidity gaps consider
amortization dates only while interest rate gaps require all
amortization dates and reset dates.
• Both gap calculations require prior definition of time bands. Liquidity
gaps consider that all amortization dates occur at some conventional
dates within time bands. Interest rate gaps assume that resets also occur
somewhere within a time band. In fact, there are reset dates in between
the start and end dates. The calculation requires the prior definition of
time bands plus mapping reset and amortization dates to such time
bands. Operational models calculate gaps at all dates and aggregate
them over narrow time bands for improving accuracy.
For any future date, any liquidity gap generates an interest rate gap. A
projected deficit of funds is equivalent to interest sensitive liability. An
excess of funds is equivalent to an interest sensitive asset. However, in
both cases, the fixed interest rate gap is the same. But pre-funding
variable interest rate gap differs from post-funding gap.
Variable Interest Rate = Variable Interest Rate – Liquidity Gap
Gap (Post-funding) Gap (Pre- funding)
While liquidity gaps include fixed assets and equity, these are excluded
from interest rate gap.
• Interest Rate Gaps and Hedging
Gaps can be easily used for hedging for the purpose of reducing
interest income volatility.
Hedging over a single period
The interest rate gap can be neutralized by using funding or derivatives
depending on the situation.
For example, if the liquidity gap is +30 and the variable rate gap is
+20 before funding, the bank can raise floating rate debt of 20 and the
remaining debt of 10 at a locked in rate as of today (through a forward
rate agreement).
If the liquidity gap is + 30 and the variable interest rate gap is +45,
after a floating rate debt of 30 is raised, there is an excess of 15 in
floating rate assets. The bank is receiving excess floating rate revenue.
This can be converted into a fixed rate revenue through an interest rate
swap (IRS) whereby a fixed rate is received and a floating rate is paid.
• Hedging over Multiple Periods
If the gaps over a three month period are –200, +50 and +100, a swap
with a notional of 200 paying the fixed rate and receiving the floating
rate would set the gap to zero at period 1. In the next period, a new
swap with a notional of 250, paying the floating rate and receiving the
fixed rate, neutralizes the gap. Actually the second swap should be
contracted from date 0 and take effect at the end of month 1. This is a
forward swap starting one month after zero. A third swap starting at
the end of month 2 and maturing at the end of month 3 neutralizes the
gap of month 3. Since the forward swap starting at the beginning of
month 2 can extend to hedge the risk of month 3, the third new swap
has a notional of only 50.
The marginal gaps represent the notionals of the different swaps
required at the beginning of each period, assuming that that the
previous hedges stay in place.
 Limitations of Interest Rate Gaps
(i) There are volume and maturity uncertainties (as in the
case of liquidity gaps). These are solved using
assumptions and multiple scenarios.
(ii) Implicit options on balance sheet and optional
derivatives off balance sheet create convexity risk.
(iii) Assets and liabilities have to be mapped to selected
interest rates as opposed to using the actual rates of
individual assets and liabilities.
(iv) There are intermediate flows within time bands selected
for determining gaps which need to be dealt with.
Mapping Assets and Liabilities to Interest Rates
Interest rate gaps assume that the variable rate assets and liabilities
carry rates following selected indexes. The process requires mapping
the actual rates to selected rates of the yield curve. It creates basis risk
if both rates differ. Sensitivities, which measure correlation between
actual and selected rates, are used to correct basis risk. The technique
is used for calculating ‘standardized gaps’.
To calculate sensitivities, the average rate of return of a subportfolio
can be regressed to the selected market index.
Rate = a0 + a1 x index + random residual
The coefficient a1 is the sensitivity of the loan portfolio rate with
respect to the index. A variation of 1% in the market index generates a
variation of the rate of loan portfolio of a1 %.
Intermediate Flows
Gaps group flows within time bands as if they were simultaneous.
In reality, there are different reset dates for liquidity flows and
interest rates. A flow with a reset date at the end of the period has
a negligible influence on the current period margin. However, if
the reset occurs at the beginning of the period, it has a significant
impact on the margin.
For example, if there is a flow of 1000 at the beginning of the
period and a flow of 1000, with an opposite sign at the end of the
period. The periodic gap of the entire period will be zero.
However, the interest margin of the period will be interest-
sensitive since the first flow generates interest revenues over the
whole period and such revenues do not match the negligible
interest cost of the second flow.
• The direct gap management or ‘gap plugging’ of margin
may create errors. For example, if a cash inflow of 1000
has a duration of 270 days in the reference period (360
days) and outflow has a duration of 180 days, the outflow
required is 1536 instead of 1000, assuming the interest rate
shifts from 8% to 10%.

Inflow at day 90 = 1000 (1.10270/360 – 1.08270/360) = -14.70

Outflow at day 180 = -1536 (1.10180/360-1.08180/360) = + 14.70