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A bank has assets with an average duration of 3 years and liabilities with an average...

A bank has assets with an average duration of 3 years and liabilities with an average duration of 1.5 years. Should it be an interest-rate swap buyer (and make fixed-rate payments) or seller (and make variable-rate payments)? Explain.

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Answer #1

THE DURATION GAP = AVERAGE DUARTION OF ASSETS - AVERAGE DUARTION OF LIABILITIES

THE DURATION GAP = 3 YEARS - 1.5 YEARS = 1.5 YEARS

DURATION GAP IS POSITIVE. SO WHEN RATE OF INTEREST INCREASES, IT BENEFITS BANK & VICE VERSA

So Bank with a positive GAP makes a floating-interest payments in exchange for a fixed-rate receipt, that is, bank is interest rate swap seller. This is because if rate falls, they will get at fixed rate but now they will pay at lower rate.

ANY DOUBTS, FEEL FREE TO ASK

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