Interest Rate Gap
What Is the Interest Rate Gap?
The interest rate gap measures a company's exposure to interest rate risk. The gap is the distance between assets and liabilities. The most normally seen instances of an interest rate gap are in the banking industry. A bank borrows funds at one rate and loans the money out at a higher rate. The gap, or difference, between the two rates addresses the bank's profit.
Formula and Calculation of the Interest Rate Gap
The interest rate gap is calculated as interest rate sensitive assets minus interest rate sensitive liabilities.
Everything the Interest Rate Gap Can Say to You
The interest rate gap shows the risk of rate exposure. Regularly, financial institutions and investors use it to foster hedge positions, frequently using interest rate futures. Gap calculations are dependent on the maturity date of the securities utilized and the period staying before the underlying securities arrive at maturity.
A negative gap, or a ratio short of what one, happens when a bank's interest rate sensitive liabilities surpass its interest rate sensitive assets. A positive gap, or one greater than one, is the inverse, where a bank's interest rate sensitive assets surpass its interest rate sensitive liabilities. A positive gap means that when rates rise, a bank's profits or incomes will probably rise.
There are two types of interest rate gaps: fixed and variable. Each measures the difference between rates on assets and liabilities and is an indicator of interest rate risk. Determination of the differential traverses a given period for both fixed and variable interest rate gaps. Interest rate gaps can likewise apply to the difference in interest rates on government securities between two unique countries.
Who Uses the Interest Rate Gap?
Institutions that profit from interest rate differentials or fund their activities with loans must keep track of the gap. A bank, which desires to borrow low and loan high, must be definitely cognizant of the yield curve. The yield curve is the difference among interest rates across the maturity range.
A flat yield curve demonstrates there is a low differential among liabilities and assets. A flat yield can be hurtful to profitability. In an extreme negative case, a yield curve might become inverted. In this case, short rates are above long rates, and loan business is actually unprofitable.
For firms that fund large projects, for example, building another nuclear power plant, the interest rate gap tells them how to secure funding. Assuming that they borrow in short-term maturities for a project that is of a long-term nature, they risk that the rate of continuing funding needs will rise, in this way inflating costs. A hedging strategy might be helpful to reduce the risk of a sizable interest rate gap.
Illustration of How to Use the Interest Rate Gap
For instance, Bank ABC has $150 million in interest rate sensitive assets (like loans) and $100 million in interest-rate sensitive liabilities, (for example, savings accounts and certificates of deposit). The gap ratio is 1.5, or $150 million partitioned by $100 million.
Or then again consider Bank of America and its 2020 year-end balance sheet. Bank of America had $1.39 billion in interest-bearing assets, which incorporates loans and rents, and debt securities. On the other hand, it has some $1.63 billion in interest-related liabilities, like deposits, short-term borrowings, and debt. In this case, Bank of America's interest rate gap is - $240 million, or $1.39 billion - $1.63 billion.
The Difference Between the Interest Rate Gap and Earnings Sensitivity
Interest rate gap analysis hopes to determine interest rate risk by taking a gander at assets versus liabilities. In the mean time, earnings sensitivity makes gap analysis a stride further. It looks past the balance sheet to what interest rates mean for a bank's earnings.
Limitations of Using the Interest Rate Gap
A negative gap may not generally be a negative for a financial institution. That is, as interest rates fall, banks earn less from interest-rate-sensitive assets; notwithstanding, they additionally pay less on their interest-related liabilities. Banks that have a higher level of liabilities than assets are the ones that see to a greater extent a burden on their main concern from a negative gap.
Highlights
- The interest rate gap decides a bank or financial institution's exposure to interest rate risk.
- A negative gap, which is an interest rate gap that is short of what one, is when rate-sensitive liabilities are greater than rate-sensitive assets, while a positive gap, which is greater than one, is the inverse.
- Hedging can be utilized to reduce the risk of a large interest rate gap.
