Management of Interest Rate Risk

Dollar Gap

Usually, banks would make use of dollar gap to manage its spread risk. Dollar gap also know as repricing gap. It applied in the bank as the simplest measure of short-term net interest exposure, or difference between assets and liabilities by comparable repricing periods based on book value cash flow analysis (Koch & MacDonald, 2006). Under this approach, the gaps for each asset and liability will be calculated by comparing the rate sensitivity of each asset and liability in each time bucket (Koch & MacDonald, 2006). The gap would be indicates in the form of either positive or negative to shows the impact of interest rate towards the earnings. A positive gap indicates that the bank’s earnings will be impacted favorably if interest rates rise during the bucket period and negatively if interest rates fall during the period. The gap statement would assume the changes in interest rate for the banks. Therefore, bank is able to forecast the change in net interest income given an assumed change in interest rate and able to achieve sustainable and stable net interest earnings in longer term by employing this repricing approach.

Duration Gap

However, the gap approach still not perfect since it does not consider the impact of market value of the assets and liabilities and just focus on short term income statement effects (Scribd, n.d). Different in terms of maturity and interest rate characteristics can cause the market value of assets and liabilities change differently. In other words, gap approach could not measure and forecast reinvestment risk effectively, as well as the price risk. Hence, duration GAP is applied in banks to forecast the interest rate and changes in market value of equity across different interest rate environment in long term. This model computes the price sensitivity of assets and liability on average as a whole. With this advanced model, bank could measure