Limitations in Reliability of Interest Rate Sensitivity Gap Case Study - 1

Limitations in Reliability of Interest Rate Sensitivity Gap - Case Study Example The researcher states that the use of the interest rate gap in measuring the interest rate risk has various limitations. When there is high volatility in the interest rate in the market the use of gap method does not yield desired results. In the duration gap approach, it is difficult to match the duration of assets with the liabilities. Besides, this analysis is useful only when there are small and identical changes in the short term and long term rates of interest. The grouping of assets and liabilities based on duration is difficult in the case of prepayments by the clients or default. When there is a fall in the interest rates the prepayment increases that make the bank â€Å"asset sensitive†. If the interest rates are anticipated to increase by 1 percent then to reduce the impact on earnings the corporation must keep a Positive Gap. This means that the rate sensitive assets should be more than the rate sensitive liabilities. If this is positive then the increase in intere st rates increases the net interest income. The Gap of the corporation is mostly positive for all the time periods except for the investments that are of less than six-month maturity. In all the classes with a positive gap, the corporation will benefit due to the anticipated increase of 1%. It will only lose on the negative gap because the net interest income will reduce for the assets and liabilities of six months maturity. The interest expense will be more on account of increase in the rate and the gap being negative i.e. the number of liabilities exceeding the number of assets, there will be a fall in the net income. The cumulative gap of the corporation is positive at $1194 million.