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.| | |
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...