Interest sensitivity gap
Encyclopedia
The interest sensitivity gap was one of the first techniques used in asset liability management
to manage interest rate risk
. The use of this technique was initiated in the middle 1970s in the United States when rising interest rates in 1975-1976 and again from 1979 onward triggered a banking crisis that later resulted in more than $1 trillion in losses when the Federal Deposit Insurance Corporation and the Federal Savings and Loan Insurance Corporation were forced to liquidate hundreds of failed institutions who had typically lent for long maturities at fixed interest rates (such as 30 year fixed rate mortgage
s) and borrowed for much shorter maturities. The interest rate sensitivity gap classifies all assets, liabilities and off balance sheet transactions by effective maturity from an interest rate reset perspective. A thirty year fixed rate mortgage would be classified as a 30 year instrument. A 15 year mortgage with a rate fixed only for the first year would be classified as a one year instrument. The interest rate sensitivity gap compares the amount of assets and liabilities in each time period in the interest rate sensitivity gap table. This comparison gives an approximate view of the interest rate risk of the balance sheet being analyzed. The interest rate sensitivity gap is much less accurate than modern interest rate risk management technology where the impact of a change in the yield curve
can be analyzed using the Heath-Jarrow-Morton framework
based on the work of researchers such as John Hull, Alan White, Robert C. Merton
, Robert A. Jarrow
and many others.
Asset liability management
In banking, asset and liability management is the practice of managing risks that arise due to mismatches between the assets and liabilities of the bank. This can also be seen in insurance....
to manage interest rate risk
Interest rate risk
Interest rate risk is the risk borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa...
. The use of this technique was initiated in the middle 1970s in the United States when rising interest rates in 1975-1976 and again from 1979 onward triggered a banking crisis that later resulted in more than $1 trillion in losses when the Federal Deposit Insurance Corporation and the Federal Savings and Loan Insurance Corporation were forced to liquidate hundreds of failed institutions who had typically lent for long maturities at fixed interest rates (such as 30 year fixed rate mortgage
Fixed rate mortgage
A fixed-rate mortgage is a mortgage loan first developed by the Federal Housing Administration where the interest rate on the note remains the same through the term of the loan, as opposed to loans where the interest rate may adjust or "float." Other forms of mortgage loan include interest only...
s) and borrowed for much shorter maturities. The interest rate sensitivity gap classifies all assets, liabilities and off balance sheet transactions by effective maturity from an interest rate reset perspective. A thirty year fixed rate mortgage would be classified as a 30 year instrument. A 15 year mortgage with a rate fixed only for the first year would be classified as a one year instrument. The interest rate sensitivity gap compares the amount of assets and liabilities in each time period in the interest rate sensitivity gap table. This comparison gives an approximate view of the interest rate risk of the balance sheet being analyzed. The interest rate sensitivity gap is much less accurate than modern interest rate risk management technology where the impact of a change in the yield curve
Yield curve
In finance, the yield curve is the relation between the interest rate and the time to maturity, known as the "term", of the debt for a given borrower in a given currency. For example, the U.S. dollar interest rates paid on U.S...
can be analyzed using the Heath-Jarrow-Morton framework
Heath-Jarrow-Morton framework
The Heath–Jarrow–Morton framework is a general framework to model the evolution of interest rate curve – instantaneous forward rate curve in particular . When the volatility and drift of the instantaneous forward rate are assumed to be deterministic, this is known as the Gaussian...
based on the work of researchers such as John Hull, Alan White, Robert C. Merton
Robert C. Merton
Robert Carhart Merton is an American economist, Nobel laureate in Economics, and professor at the MIT Sloan School of Management.-Biography:...
, Robert A. Jarrow
Robert A. Jarrow
Robert Alan Jarrow is the Ronald P. and Susan E. Lynch Professor of Investment Management at the Johnson Graduate School of Management, Cornell University...
and many others.