Question

you have $50 million to invest in the securities of one of two Financial institutions labelled A and B. A has a duration gap of +2.44. while B has a duration gap of - 0.87

Explain the conditions under which you would choose to invest in a particular institution.

Answer 1

Solution:

When positive duration gap then decrease in interest rate will lead to increase in equity value and When negative duration gap then increase in interest rate will lead to increase in equity value.

Duration Gap = DA - DL * Total Liability / Assets

So when we think that the interest rate will rise then we should invest in B that has negative duration gap and

when we think that the interest rate will fall then we should invest in A that has positive duration gap.