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FRM Part II · FRM Exam Part II · Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques

A bank has assets of $500 million with duration 6.0 years and liabilities of $450 million with duration 5.0 years. Equity is $50 million. Which statement about the bank's interest rate exposure is most accurate?

The leverage-adjusted duration gap is 1.5 years (6.0 minus 0.9 x 5.0). Because it is positive, assets fall in value by more than liabilities when rates rise, so equity value declines. The simple 1.0-year gap ignores leverage and understates the exposure.

  1. AThe leverage-adjusted duration gap is 1.5 years, so a rate rise reduces equity valueCorrect
  2. BThe simple duration gap of 1.0 year is the correct measure of exposure, so equity falls by 1% of assets per 1% rate rise
  3. CThe leverage-adjusted duration gap is 0.5 years, so a rate rise reduces equity value
  4. DThe leverage-adjusted duration gap is 1.5 years, so a rate rise increases equity value

Explanation

Leverage-adjusted gap = 6.0 - (450/500) x 5.0 = 6.0 - 4.5 = 1.5 years. Positive gap means assets lose more value than liabilities when rates rise, so equity falls. The simple gap of 1.0 ignores leverage and understates exposure.

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