Question

(TCO E) How do prepayments, calls, defaults and changes in the shape of the yield curve affect the duration gap measurement tool?

Answer 1

Ans :

1.Prepayments and calls are practically difficult to predict exactly, based on historic data we can judge or take an idea of the same, they can change the duration of the respective accounts.

2.Defaults are not considered in the model and they have major impact on profitability and equity value.

3. Changes in shape of the yield curve does mean that interest rate changes for different maturity by different value

So, ΔR must be interpreted by the average change in interest rate and ΔE is also being estimated/approximated by using the actual change in equity value.

All these real world factors are diffciult to incorporate into the model and assumptions has been made to give an approximated value using the duration gap measurment tool.