Alm Gap Analysis

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Gap analysis is a technique of asset-liability management that can be used to assess interest rate risk or liquidity risk. Implementations for those two applications differ in minor ways, so people distinguish between interest rate gaps and liquidity gaps. This article discusses both. Gap analysis was widely adopted by financial institutions during the 1980s. When used to manage interest rate risk, it was used in tandem with duration analysis. Both techniques have their own strengths and weaknesses. Duration is appealing because it summarizes, with a single number, exposure to parallel shifts in the term structure of interest rates. It does not address exposure to other term structure movements, such as tilts or bends. Gap analysis is more cumbersome and less widely applicable, but it assesses exposure to a greater variety of term structure movements. Changes in the Term Structure of Interest Rates

Exhibit 1|
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The term structure of interest rates can move in many ways. Duration analysis addresses exposure to parallel shifts only. Gap analysis can warn of exposure to more complex movements, including tilts and bends.| |  |

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Let's start our discussion with cash flow matching (or simplycash matching). This is an effective, but largely impractical means of eliminating interest rate risk. If a portfolio has a positive fixed cash flow at some time t, its market value will increase or decrease inversely with changes in the spot interest rate for maturity t. If the portfolio has a negative fixed cash flow at time t, it's market value will increase or decrease in tandem with changes in that spot rate. Stated simply, interest rate risk arises from either positive or negative net future cash flows. The concept of cash matching is to eliminate interest rate risk by eliminating all net future cash flows. A portfolio is cash matched if every future cash inflow is balanced with an offsetting cash outflow on the same date, and every future cash...
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