The interest sensitivity gap was one of the first techniques used in
asset liability management
Asset and liability management (often abbreviated ALM) is the practice of managing financial risks that arise due to mismatches between the assets and liabilities as part of an investment strategy in financial accounting.
ALM sits between risk ...
to manage
interest rate risk. The use of this technique was initiated in the middle 1970s in the United States when rising interest rates in 1975-1976 and again from 1979 onward triggered a banking crisis that later resulted in more than $1 trillion in losses when the Federal Deposit Insurance Corporation and the Federal Savings and Loan Insurance Corporation were forced to liquidate hundreds of failed institutions who had typically lent for long maturities at fixed interest rates (such as 30 year
fixed rate mortgage
A fixed-rate mortgage (FRM) is a mortgage loan where the interest rate on the note remains the same through the term of the loan, as opposed to loans where the interest rate may adjust or "float". As a result, payment amounts and the duration of th ...
s) and borrowed for much shorter maturities. The interest rate sensitivity gap classifies all assets, liabilities and off balance sheet transactions by effective maturity from an interest rate reset perspective. A thirty-year fixed rate mortgage would be classified as a 30-year instrument. A 15-year mortgage with a rate fixed only for the first year would be classified as a one-year instrument. The interest rate sensitivity gap compares the amount of assets and liabilities in each time period in the interest rate sensitivity gap table. This comparison gives an approximate view of the interest rate risk of the balance sheet being analyzed. The interest rate sensitivity gap is much less accurate than modern interest rate risk management technology where the impact of a change in the
yield curve
In finance, the yield curve is a graph which depicts how the yields on debt instruments - such as bonds - vary as a function of their years remaining to maturity. Typically, the graph's horizontal or x-axis is a time line of months or ye ...
can be analyzed using the
Heath-Jarrow-Morton framework based on the work of researchers such as
John Hull, Alan White,
Robert C. Merton
Robert Cox Merton (born July 31, 1944) is an American economist, Nobel Memorial Prize in Economic Sciences laureate, and professor at the MIT Sloan School of Management, known for his pioneering contributions to continuous-time finance, especia ...
,
Robert A. Jarrow
__NOTOC__
Robert Alan Jarrow is the Ronald P. and Susan E. Lynch Professor of Investment Management at the Johnson Graduate School of Management, Cornell University. Professor Jarrow is a co-creator of the Heath–Jarrow–Morton framework for ...
and many others.
References
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Sensitivity gap