Q1. Discuss limitations in the reliability of the interest rate-sensitivity gap. As implied in the case, the methodology is to classify assets and liabilities in terms of the time to certain repricing events (maturity, adjustment upon a change in market rates, amortization of a portion of principal, expected prepayment of certain assets, and early withdrawal of liabilities before maturity). What factors would you cite to show weaknesses in the precision of the methodology for creating the interest rate-sensitivity gap report?
Limitations in the reliability of the interest rate-sensitivity gap as follows:
Gap analysis does not capture basis risk or investment risk, is generally based on parallel shifts in the yield curve, does not incorporate future growth or changes in the mix of the business, and doest not account for the time value of money. Moreover, simple gap analysis (based on contractual term to maturity) assumes that the timing and amount of assets and liabilities maturing within a specific gap period are fixed and determined, therefore ignoring the effects of principal and interest cash flows arising from honoring customer drawdowns on credit commitments, deposit redemptions and prepayments, either on mortgage or term loans, as well as the timing of maturities within the gap period. Depending on the interest rate environment, the mix of assets and liabilities (both on and off balance sheet), and the exercise of credit and deposit options by customers, these deficiencies may represent a significant interest rate risk to an institution.
Limitations inherent in most GAP reports are as follows:-
The focus of a gap report is on the level of net repricings. The assumption is that within a given time band, assets and liabilities fully offset or “hedge” each other. In practice, however, assets and liabilities price off different yield curves or indices and do not move at all...