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# DURATION GAP IN THE CONTEXT OF A BANK'S STRATEGIC PLANNING PROCESS

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This paper presents an approach to duration that adds depth and realism to the subject of duration gap, which is usually presented as a “stand alone” issue in much of the banking literature. Duration is an important tool used by managers, but many overly simplified examples are not consistent with operating realities. This study offers a more realistic approach to measuring portfolio duration and duration gap which will enhance the bank’s strategic planning process.
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Journal of Financial and Strategic Decisions
Volume 13 Number 2 Summer 2000

DURATION GAP IN THE CONTEXT OF A
BANK’S STRATEGIC PLANNING PROCESS

Kristine L. Beck*, Elizabeth F. Goldreyer* and Louis J. D’Antonio*

Abstract

This paper presents an approach to duration that adds depth and realism to the subject of duration gap, which
is usually presented as a “stand alone” issue in much of the banking literature. Duration is an important tool
used by managers, but many overly simplified examples are not consistent with operating realities. This study
offers a more realistic approach to measuring portfolio duration and duration gap which will enhance the
bank’s strategic planning process.

INTRODUCTION

While rates have remained relatively low and stable recently, institutions must still be prepared for rising interest
rates. Duration matching represents a powerful tool in minimizing the risk of changing interest rates. It is an
important tool utilized by the decision-makers in risk management issues. However, currently there are many
illustrations that provide overly simplified definitions of portfolio duration and its use in immunization strategies to
reduce interest rate risk. Unfortunately, many examples are not accurate or are not consistent with operating
realities. This study offers a more realistic approach to measuring portfolio duration and duration gap. We offer
illustrations correcting for some of the oversimplified examples of portfolio duration found in the literature. Further,
we apply the corrected portfolio duration to an immunization example for a bank using duration gap.
Several authors have addressed the problem of oversimplification or mistakes in illustrations of duration and
immunization. Bierwag and Kaufman [1] attempt to clarify duration gap for financial institutions by providing
several single-factor duration gap equations. The authors explain that since immunization will depend on the
account the institution targets as its primary concern, different duration gap equations should be adopted for
alternative “target” accounts. While noting that Macaulay’s duration is accurate in describing a security’s price
sensitivity only if the yield curve is flat and shifts in the yield curve are parallel, these authors choose to use this less
realistic measure of duration so that they can focus on the differences in the duration gap measure resulting from the
choice of desired target account.
Shaffer [11] also expresses concern over the restrictive condition of a flat yield curve in using Macaulay’s
duration and adds that changes in interest rates must be small for immunization to be effective. He concludes that
these restrictive conditions are one reason why many financial institutions have been hesitant to adopt duration gap
as a means of controlling interest rate risk. While Shaffer describes a perfectly hedged bank as one whose “duration
of its assets, weighted by dollars of assets, equals the duration of its liabilities, weighted by dollars of liabilities,” he
notes that this is true only under simplifying assumptions.
Cherin and Hanson [2] examine the immunization strategy of matching the duration of a fixed income portfolio
with investment horizon. They point out that most illustrations concentrate on the duration of principal payments but
ignore the duration of accumulated interest payments. More specifically, these illustrations present a change in
principal value when interest rates change (i.e., when interest rates decrease, the bond’s market value increases), but
do not show a similar change in the value of accumulated interest. The authors suggest that a more compatible
treatment would be to assume both principal and accumulated interest are invested in bonds that are duration-
matched to the investment horizon, therefore resulting in an increase in the values of both principal and accumulated

*University of Denver
57

58
Journal of Financial and Strategic Decisions
interest when interest rates decline. They demonstrate, through an example, that applying this assumption and
rebalancing the portfolio to maintain duration equal to the investment horizon will lead to complete immunization.
While the works by Bierwag and Kaufman [1], Cherin and Hanson [2], and Shaffer [11] sited above provide an
excellent framework for analyzing the problem of risk-management faced by financial institutions, many fail to
utilize this framework in a realistic fashion. In fact many bank related works portray duration gap as:1

The net worth of any bank is equal to its assets less its liabilities. By equating duration of assets and
duration of liabilities, a bank can immunize its net worth against changes in interest rates. The goal is
to make the duration gap (duration of asset portfolio minus duration of bank liabilities) as close to zero
as possible.

There are two flaws with the analysis for the strategic planner at financial institutions. First, this goal implies that
a bank needs to ensure that the duration of the assets is equal to the duration of the liabilities multiplied by the ratio
of the total liabilities to the total assets. However, our study will demonstrate that this simplified relationship implies
some assumptions that are unrealistic to banking operations. In addition, these authors, along with Saunders [10] and
Madura [7], define the duration of a portfolio as equaling the dollar weighted average of the duration of each
individual asset in the portfolio. We will illustrate below that this is an accurate representation of portfolio duration
only if the yields on the financial instruments are the same. Haugen [5] and Tuckman [13] provide additional
illustrations.

PORTFOLIO DURATION

In some instances simplifying assumptions can cause confusion for the manager as he or she tries to reconcile the
presentation of duration gap relative to bank operating realities. For example, one might question whether the yield
and duration of a portfolio of fixed income instruments are actually equal to the dollar-weighted average of the
yields and duration of each individual asset. If we examine this issue using two zero coupon bonds, we can
demonstrate that the weighted average yield and duration of the individual assets are not necessarily equal to that of
the portfolio as a whole. Zero coupon bonds are ideal for illustration, since Macaulay duration is equal to maturity
for zero coupon bonds. Table 1 provides a comparison between current text illustrations of portfolio duration
(simple weighted average duration) and the correct calculation of portfolio duration (actual portfolio duration). The
simple weighted average duration provided in this table and the next (Table 2) are comparable to examples provided
in literature directed at bank managers (including those cited in this paper). A one-year 6% yield to maturity (YTM)
zero coupon bond and a ten year 12% YTM zero coupon bond are used in the illustration. The simple weighted
average yield and duration are 9% and 5.5 years, respectively, while the portfolio yield and the Macaulay duration of
the portfolio are 11.47% and 5.7 years. The modified duration for the simple weighted average and portfolio
duration are 5.05 and 5.11, respectively.

TABLE 1
Portfolio Duration Example
Simple versus Actual Portfolio Duration

Summary: Simple Weighted Average Actual Portfolio Duration
Duration (in current texts) (suggested by authors)
Yield 9% 11.47%
Macaulay Duration 5.5 years 5.7 years
Modified Duration 5.05 5.11

Duration Gap in the Context of a Bank’s Strategic Planning Process
59
TABLE 1
Portfolio Duration Example
Simple versus Actual Portfolio Duration
(Cont’d)

Security 1 1 year zero coupon bond, yield 6%, current market price8 = \$1,000,
maturity value in one year = \$1,060.00
Security 2 10 year zero coupon bond, yield 12%, current market price = \$1,000,
maturity value in ten years = \$3,105.85

Present value of the portfolio = \$1,000 + \$1,000 = \$2,000

Simplified Versions in Current Texts

Simple weighted average yield = .5(6%) + .5(12%) = 9%
Simple weighted average Macaulay duration = .5(1 year) + .5(10 years) = 5.5 years
Simple weighted average modified9 duration = 5.05

Correct Version

Actual Portfolio yield and duration:

CF
CF
CF
CF
Price
1
2
9
10
=
+
+
+
+
portfolio
......

1
2
9
10
1
( + y)
1
( + y)
1
( + y)
1
( + y)

1060
0
0
3105.85
\$2 000
,
=
+
+ ......+
+

1
2
9
10
1
( + y)
1
( + y)
1
( + y)
1
( + y)

Yieldportfolio = 11.47%

950
\$
93
.
1
( ) + 1
\$ 048
,
.58 10
(
)
Macaulay Duration
=
portfolio =
5 7
. years
2
\$ 000
,

Modified Duration portfolio = 5.11

If we expand the illustration presented in Table 1 to take into account the fact that a bank’s asset portfolio would
be represented by a diverse group of investments, the disparity would be equally pronounced. Table 2A provides a
simplified hypothetical bank balance sheet. This balance sheet is similar to examples provided in current texts. The
simple weighted average yield and modified duration for the assets of the balance sheet (Table 2A) are calculated to
be 9.75% and 5.2, respectively. The yield and duration that describes the bank’s portfolio would in fact be
determined by the portfolio’s cash flows. Given the value of the portfolio and its periodic cash flows illustrated in
Table 2B, the overall portfolio yield is found to be 10.22% and the modified duration is 4.90. This represents a
significant difference from the simple weighted average.

60
Journal of Financial and Strategic Decisions
TABLE 2
Bank Asset Portfolio
Simple versus Actual Portfolio Duration

Summary: Simple Weighted Average Actual Portfolio
Yield 9.75% 10.22%
Modified Duration 5.20 4.90

TABLE 2A: Simple Weighted Average Duration
Asset
Yield to
Investment
Modified Duration
Maturity
1 year T-bill
5%
\$ 1 million
.95
2 year installment loan (consumer)
14%
\$ 1 million
1.30
10 year zero coupon strip
12%
\$ 1 million
8.93
30 year fixed rate mortgage
8%
\$ 1 million
9.44
Simple weighted average yield = .25(5% + 14% + 12% + 8%) = 9.75%
Simple weighted average modified duration = .25(.95 + 1.30 + 8.93 + 9.44) = 5.2

TABLE 2B: Actual Portfolio Duration
Asset10
Present
Y1
Y2 …
Y10 …
Y30
Value
1 year T-bill
\$ 1 million
1,050,000
0
0
0
2 year installment loan
\$ 1 million
607,290
607,290

(consumer)
10 year zero coupon strip

\$ 1 million
0
0
3,105,848
0
30 year fixed rate mortgage
\$ 1 million
88,827
88,827
88,827
88,827
1 746
,
117
,
696 117
,
88 827
,
88,827
3 194
,
675
,
88,827
\$ 4,000,000 = (
+
+
+ ...+
+
+ ...+

1 + y)1
(1+ y)2 (1+ y)3
(1+ y)9 (1+ y)10
(1+ y)30
Yieldportfolio = 10.22%
Macaulay Durationportfolio = 5.4 years
Modified Durationportfolio = 4.90

DURATION GAP

Once we have attained the correct duration of the bank’s asset portfolio, one must determine the duration of the
bank’s liabilities in order to compute the bank’s duration gap. If we assume that the bank desires a duration gap
equal to zero, then according to some prevailing bank texts, its capital will be immunized when the duration of the
assets is equal to the duration of the liabilities (DA=DL). The only necessary adjustment being the application of the
ratio of bank liabilities to total assets such that a duration gap equal to zero is attained when:

Equation 1

s
TotalAsset

D
DL = DA
A =
lities
TotalLiabi
DL

or
 .

s
TotalAsset

lities
TotalLiabi

Duration Gap in the Context of a Bank’s Strategic Planning Process
61
As was the case with the prevailing use of the simple weighted average, this simplification may also lead to
confusion. If one views duration as an elasticity where

Equation 2
P
P
D = Elasticity =
,
r
∆ (1+r)

then it can be shown in Equation 3 below that:2

Equation 3
rPD

P
∆ = (
,
1 + r )

where r = market rate of interest, P = price or principal amount, and D = duration. Using the accounting identity A =
L + C, where A = assets, L = liabilities, and C = capital, one can show that for the bank’s capital to be immunized,
the change in owner’s equity, C, must equal zero when rates change. For this to occur for any given change in r,
the change in the value of the bank’s assets, A, must equal the change in the bank’s liabilities, L.

Using Equation 3 we can equate the change in the value of the bank’s assets relative to its liabilities in the
following way:

Equation 4
r
P D
r
P D
∆ =
=
= ∆
A
P
( A A A
P ,
1 + r
1 + r
A )
( L L )L
L
L

where the A subscript represents assets and the L subscript represents liabilities. While this relationship is
algebraically correct, it unfortunately does not address the specific operating characteristics that are essential to bank
operations. From this expression the change in the dollar value of the assets (P A) equals the change in the dollar
value of the liabilities (P L) when the duration of the assets (DA) equals the duration of the liabilities (DL) if the
following assumptions hold true:

1. The rate of return on the assets (rA) is equal to the rate of return on the liability (rL).
2. The dollar value of the assets (PA) is equal to the dollar value of the liability (PL) used to fund the asset.
3. The change in the rate of interest in the asset market (r A) is equal to the change in the rate of interest in
the liability market (r L).

However, the above assumptions are in direct conflict with basic bank operations. For example, the average cost
of the bank’s liabilities should be less than the overall yield on the bank’s assets. Therefore in reality, rA > rL. If we
relax assumption (1) and incorporate the inequality of rA and rL into Equation 4, C = 0 is achieved when:

Equation 5
D
+
A (1
L
r )
D =
L
(
.3
1 + rA )

If we relax the second assumption, one can state that in at least some cases, in order to fund the bank’s assets, the
dollar amount of the liabilities will in fact have to vary from that of the funded asset. With the current risk-based
capital adequacy standards, the amount of capital and therefore liabilities necessary to fund those assets may differ
significantly given the risk nature of the assets and the reserves required on the liability. Clouse, D’Antonio, and
Fluck [3] present an approach for dealing with capital adequacy in a dynamic framework. Currently, the simple
dollar volume of the assets does not determine the amount of capital and therefore liabilities used to fund the asset
portfolio. Consequently, PA will not equal PL. Given the fact that the bank can determine its capital adequacy needs
and Federal Deposit Insurance Corporation (FDIC) premiums and reserve requirements, a more accurate adjustment

62
Journal of Financial and Strategic Decisions
would be to take them into account directly and not simply use the ratio of total liabilities to total assets, as is so
often shown to be the case.
Relaxing assumption (2) leads to a further adjustment to Equation 4. Let N represent the portion of the bank’s
liabilities necessary to fund non-earning assets and other obligations. When capital adequacy dictates that equity
capital would exceed the level of the bank’s fixed assets (i.e. premises), N may be negative. Therefore PA, the dollar
value of the assets, can always be expressed in terms of PL, the dollar value of the liabilities:

Equation 6
= −
A
P
(1 N) LP .

Taking the realities of funds management into account would indicate that C=0 when:

Equation 7
D 1 N 1 + r
A (
)( L)
D =
L
(
.4
1 + rA )

Since bank managers are well aware that the asset and liability mix of the bank is comprised of instruments from
different markets, the change in interest rates across those markets most likely will not be the same. The final
adjustment takes into account varying interest rate changes across the asset and liability markets. This allows one to
express the duration of the liability mix necessary to immunize the bank’s capital in terms of the duration of the
asset mix. Mathematically it is shown to be:

Equation 8
D 1 N 1 + r
r

A (
)( L )( A)
D =
L
(
,
1 + r
r

A )(
A )

where rA is the portfolio yield and rL is the portfolio cost. 5

EXAMPLE

At this point, a simple example might be useful in illustrating the appropriate adjustment. In order to minimize
the complexity of our illustration, we do not incorporate Cherin and Hanson’s [2] concept of including the duration
of accumulated interest payments. Table 3A shows a bank balance sheet in which the simple weighted average
modified duration of assets is 4.99 and of liabilities is 3.98. The simple weighted average yield for the assets
portfolio is 7.80%, while the simple weighted average cost for the liabilities is 7.33%.6
Table 3B computes the actual duration for the portfolio of assets and liabilities. Both differ from the simple
weighted average duration from Table 3A. The modified duration of the assets is 5.22, and the modified duration of
the liabilities is 4.18. The actual portfolio yield (8.82%) and cost (8.47%) from Table 3B also differ from the simple
weighted average yield (7.80%) and simple weighted average cost (7.33%) in Table 3A.
Table 4 determines the duration of the bank’s liabilities required so that the bank’s capital is immunized. First,
we use the simplified Equation 1 with the simple weighted average modified duration of assets of 4.99 from Table
3A to calculate the required modified duration of liabilities of 5.66. Under the more realistic relationship, we use
Equation 8 to compute the required liability duration. We then explore two cases. The first case assumes N, the
portion of the bank’s liabilities necessary to fund non-earning assets, is equal to zero. This allows PA to equal PL.
The second case uses a more realistic assumption of N equal to three percent. In both cases, we consider the same
varying rate changes across the asset and liability markets, or r L=1% and r A=0.5%. The computed duration of
liabilities is significantly smaller under the more realistic relationship developed in Equation 8: 2.6 for case (1) and
2.52 for case (2). This disparity will have significant consequences for a bank’s capital in an environment of
changing interest rates. Equation 1 would not lead to a duration gap equal to zero and therefore the bank’s capital
would not be immunized.7

Duration Gap in the Context of a Bank’s Strategic Planning Process
63
TABLE 3
A Simple Banking Example
Simple versus Actual Portfolio Duration

Summary: Simple Weighted Average Actual Portfolio
Assets
Yield 7.80% 8.82%
Modified Duration 4.99 5.22

Liabilities
Yield 7.33% 8.47%
Modified Duration 3.98 4.18

TABLE 3A: Simple Weighted Average Duration
Assets
Market Value
Yield / Cost
Modified
Duration

Cash and Due
\$ .5 million
0%
0
1 year US Treasury Bills
10.25 million
5%
.95
2 year Commercial Installment Loans
10.25 million
9%
1.36
20 year US Treasury Bond
10.25 million
8%
9.82
30 year Real Estate Loans
10.25 million
10%
8.34
Bank Premises
.5 million
0%
0
Total Assets
\$42 million

Simple weighted average yield = (10/41) x (5% + 9% + 8% + 10%) = 7.80%
Weighted average modified duration of assets = (10/41) x (.95 + 1.36 + 9.82 + 8.34) = 4.99

Liabilities
Market Value
Yield / Cost
Modified
Duration

Demand Deposits
\$ 1 million
0%
0
1 year Negotiable CD11
12 million
6%
.94
2 year Other Time Deposits11
12 million
7%
1.87
20 year Subordinated Notes
12 million
9%
9.13
Total Liabilities
\$37 million

Stockholder’s Equity
5 million

Total Liabilities and Stockholder’s Equity
\$42 million

Simple weighted average cost = (12/36) x (6% + 7% + 9%) = 7.33%
Weighted average modified duration of liabilities = (12/36) x (.94 + 1.87 + 9.13) = 3.98

64
Journal of Financial and Strategic Decisions
TABLE 3B: Actual Portfolio Duration
Cash Flows (Assets)
Y1
Y2 …
Y5 …
Y20 …
Y30
\$.5 million cash and due

\$10.25 million 1 year T bills
\$10,726,500

\$10.25 million 2 year Commercial Loan
5,826,806 \$5,826,806 …

\$10.25 million 20 year Treasury Bond
820,000
820,000 … \$ 820,000 … \$11,070,000 …

\$10.25 million 30 year Real Estate Loan
1,087,312
1,087,312 …
1,087,312 …
1,087,312 … \$1,087,312
\$.5 million Bank Premises

18 496
,
618
,
7 734
,
118
,
1,907,312
1,907,312
12 157
,
312
,
1 087
,
,312
1 087
,
,312
41
\$
000
,
000
,
=
+
+
+ L
+
+
L +

1
2
3
19
20
21
30
1
( + y)
1
( + y)
1
( + y)
1
( + y)
1
( + y)
1
( + y)
1
( + y)
Portfolio Yield = 8.82%
Portfolio Modified Duration = 5.22

Cash Flows (Liabilities)
Y1
Y2 …
Y5 …
Y20

\$1 million Demand Deposits

\$12 million 1 year Neg. CD
\$12,720,000

\$12 million 2 year Other Time Deposits
\$13,738,800 …

\$12 million 20 year Subordinated Notes
1,080,000
1,080,000 … \$1,080,000 …
13 800
,
000
,
14,818,800
1 080
,
000
,
1 080
,
000
,
13 080
,
000
,
36
\$
000
,
000
,
=
+
+
+ L +
+

1
2
3
19
20
1
( + y)
1
( + y)
1
( + y)
1
( + y)
1
( + y)
Portfolio Cost = 8.47%
Portfolio Modified Duration = 4.18

CONCLUSION

This paper demonstrates that the yield and duration of a portfolio of fixed income instruments are not necessarily
equal to the weighted average of the yields and duration of each individual asset. In addition, we directly integrate
both funds management and capital adequacy with portfolio duration. Our approach not only uses duration matching
to minimize interest rate risk, it allows: (1) the rate of return on assets to exceed the rate of return on liabilities, and
(2) the dollar value of the assets to differ from the dollar value of the liabilities used to fund those assets.
Consequently, we address the major realities facing bank managers when making their strategic decisions.
This approach provides a touch of realism to the process of bank management as opposed to dealing with
duration gap as a “stand alone” issue. Many examples do not address these realities and may therefore lead to
misleading results. As a consequence, the banks strategic planning process may be misguided as a result of focusing
on inappropriate goals and targets.

Duration Gap in the Context of a Bank’s Strategic Planning Process
65
TABLE 4
Immunization Example

Using Equation 1, the simplified relationship is:

s
TotalAsset

42
\$
million
D
.
L = D A
 = 4 
99

 = 5.66

lities
TotalLiabi

37
\$
million

where DA is the weighted average modified duration of assets.

Using Equation 8, the more realistic relationship is:

D

+

A (1
N )(1
L
r )( rA )
D =
L
(
,
r

1 + r
L )(
A )

where DA is the portfolio modified duration.

Case (1): N=0, r L=1%, and r A=0.5%

.
5
(
22 1 0) (1 + .0847) (.005)
D =
L
= 2.60
(.
)
01 (1 + .0882)

Case (2): N=3%, r L=1%, r A=0.5%

.
5
(
22 1 − . )
03 (1 + .0847) (.
)
005
D =
L
= 2.52
(.
)
01 (1 + .
)
0882

ENDNOTES

1. Examples include texts by Rose [8], Thygerson [11], Mishkin and Eakins [7], Koch [5], and Gardner and Mills [3].
2. See Rose [8].
3. The algebraic derivation of Equation 5 from Equation 4 and assumptions (2) and (3) is shown in Appendix A.
4. The derivation of Equation 7 from Equations 4 and 6 and assumption (3) is shown in Appendix A.
5. The derivation of Equation 8 from Equations 4 and 6 is shown in Appendix A.
6. Calculations are provided in Appendix B.
7. See Appendix C.
8. The prices of the bonds are both \$1,000 to illustrate the simple weighted average yield and duration clearly with 50%
weights. Normally, zeros would sell at a discount and have maturity value of \$1,000.
9. Modified duration is calculated as the Macaulay duration divided by (1+YTM).
10. The prices, or present values, of the bonds are chosen to preserve equal weights in the portfolio. The one-year Treasury bill,
for example, would actually be sold at a discount and have maturity value of \$1 million.
11. For simplicity, interest is assumed to be paid at the end of the period.

66
Journal of Financial and Strategic Decisions
REFERENCES

1. Bierwag, G.O. and George G. Kaufman, “Duration Gap for Financial Institutions,” Financial Analysts Journal 41,
March/April 1985, pp. 68-71.
2. Cherin, Antonio C. and Robert C. Hanson, “Consistent Treatment of Interest Payments in Immunization Examples,”
Financial Practice and Education 7, No. 1, Spring/Summer 1997, pp. 122-126.
3. Clouse, Mac, Lou D’Antonio and Roland Fluck, “A Strategic Planning Model for Bank Capital Adequacy,” The Journal of
Financial and Strategic Decisions 3, Winter 1990, pp.73-93.
4. Gardner, Mona J., and Dixie L. Mills, Managing Financial Institutions: An Asset/Liability Approach, 2nd Ed., 1991,
Chicago, IL, The Dryden Press.
5. Haugen, Robert A., Modern Investment Theory, 4th Ed., 1997, New Jersey, NY, Prentice Hall.
6. Koch, Timothy W., Bank Management, 1988, Chicago, IL, The Dryden Press.
7. Madura, Jeff, Financial Markets and Institutions, 4th Ed., 1988, Cincinnati, OH, South-Western College Publishing.
8. Mishkin, Frederic S. and Stanley G. Eakins, Financial Markets and Institutions, 2nd Ed., 1988, Menlo Park, CA, Addison-
Wesley.
9. Rose, Peter S., Commercial Bank Management, 3rd Ed., 1996, Chicago, IL, Irwin.
10. Saunders, Anthony, Financial Institutions Management - A Modern Perspective, 2nd Ed., 1997, Chicago, IL, Irwin.
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