Question

What is the duration gap for an investor with a year horizon who invests in a bond with a duration of 10?

Answer 1

Duration gap is defined as the difference between the duration of assets and liabilities held by an entity. So it measures how well matched are the timings of cash inflows (from assets) and cash outflows.

Duration gap = Duration of assets - duration of liabilities

A one year investment horizon can be interpreted as need of cash inflows in one year, so here the duration of liabilities is 1 year.

Thus, duration gap = 10- 1 = 9

Note that if the sizes of assets & liabilitieas are different, we need to modify the liabilities term in above formula by multiplying with ratio of liabilities to assets.