TABLE 1: Duration of the First National Banks Assets and Liabilities

Weighte
d
Amount Duration Duration
($ millions) (years) (years)
Assets
Reserves and cash items 5 0.0 0.00
Securities
Less than 1 year 5 0.4 0.02
1 to 2 years 5 1.6 0.08
Greater than 2 years 10 7.0 0.70
Residential mortgages
Variable-rate 10 0.5 0.05
Fixed-rate (30-year) 10 6.0 0.60
Commercial loans
Less than 1 year 15 0.7 0.11
1 to 2 years 10 1.4 0.14
Greater than 2 years 25 4.0 1.00
Physical capital 5 0.0 0.00

Average duration 2.70

Liabilities
Checkable deposits 15 2.0 0.32
Money market deposit accounts 5 0.1 0.01
Savings deposits 15 1.0 0.16
CDs
Variable-rate 10 0.5 0.05
Less than 1 year 15 0.2 0.03
1 to 2 years 5 1.2 0.06
Greater than 2 years 5 2.7 0.14
Fed funds 5 0.0 0.00
Borrowings
Less than 1 year 10 0.3 0.03
1 to 2 years 5 1.3 0.07
Greater than 2 years 5 3.1 0.16

Average duration 1.03

Deposits are determined by multiplying the 2.0-year duration by $15 million divided by
$95 million to get 0.32. Adding up these weighted durations, the manager obtains an
average duration of liabilities of 1.03 years.
EXAMPLE 1: Duration Gap Analysis
The bank manager wants to know what happens when interest rates rise from 10% to
11%. The total asset value is $100 million, and the total liability value is $95 million.
Solution
With a total asset value of $100 million, the market value of assets falls by $2.5 million
= ($100 million * 0.025 = $2.5 million):

Where,
DUR = duration = 2.70
i = change in interest rate = 0.11 - 0.10 = 0.01
i = interest rate = 0.10

Thus:

With total liabilities of $95 million, the market value of liabilities falls by $0.9 million
= ($95 million * 0.009 = -$0.9 million):

Where,
DUR = duration = 1.03
i = change in interest rate = 0.11 - 0.10 = 0.01
i = interest rate = 0.10

Thus:

The result is that the net worth of the bank would decline by $1.6 million
= (-$2.5 million - (-$0.9 million)=-$2.5 million + $0.9 million = -$1.6 million)
The bank manager could have gotten to the answer even more quickly by calculating
what is called a duration gap, which is defined as follows:

Where,
DURa = average duration of assets
DURl = average duration of liabilities
L = market value of liabilities
A = market value of assets
EXAMPLE 2: Duration Gap Analysis
Based on the information provided in Example 1, use Equation 2 to determine the
duration gap for First National Bank.
Solution
The duration gap for First National Bank is 1.72 years:

Where,
DURa = average duration of assets= 2.70
L = market value of liabilities= 95
A = market value of assets = 100
DURl = average duration of liabilities = 1.03

Thus:

To estimate what will happen if interest rates change, the bank manager uses the DURgap
calculation in Equation 1 to obtain the change in the market value of net worth as a
percentage of total assets. In other words, the change in the market value of net worth as
a percentage of assets is calculated as:

EXAMPLE 3: Duration Gap Analysis

What is the change in the market value of net worth as a percentage of assets if interest
rates rise from 10% to 11%?
Solution
A rise in interest rates from 10% to 11% would lead to a change in the market value of
net worth as a percentage of assets of 21.6%:

Where
DURgap = duration gap = 1.72
i = change in interest rate = 0.11 - 0.10 = 0.01
i = interest rate = 0.10
Thus:

With assets totaling $100 million, Example 3 indicates a fall in the market value of net
worth of $1.6 million, which is the same figure that we found in Example 1.
As our examples make clear, both income gap analysis and duration gap analysis indicate
that the First National Bank will suffer from a rise in interest rates. Indeed, in this
example, we have seen that a rise in interest rates from 10% to 11% will cause the market
value of net worth to fall by $1.6 million, which is one-third the initial amount of bank
capital. Thus the bank manager realizes that the bank faces substantial interest rate risk
because a rise in interest rates could cause it to lose a lot of its capital. Clearly, income
gap analysis and duration gap analysis are useful tools for telling a financial institution
manager the institutions degree of exposure to interest-rate risk.