If a bank has a duration gap of two years,a rise in interest rates from 5 to 8% per annum will lead to a/an:
A) increase of 5.71% in the market value of its net worth.
B) fall of 5.71% in the market value of its net worth.
C) increase of 5.71% in net interest income.
D) fall of 5.71% in net interest income.

Question

Quizplus · Accepted Answer

A duration gap of two years means that the bank's assets have an average maturity of two years while its liabilities have an average maturity of less than two years. When interest rates rise, the value of assets with longer maturity declines at a higher rate than the value of liabilities with shorter maturity. As a result, the market value of the bank's net worth will fall. The percentage change in market value can be estimated as -2 x duration gap x change in interest rate. In this case, the percentage change will be -2 x 2 x (8%-5%) = -5.71%, indicating that the market value of the bank's net worth will fall by 5.71% due to the interest rate increase.

If a Bank Has a Duration Gap of Two Years,a