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Uses of Maturity Gap and Duration Gap

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a. Explain how portfolio managers can use maturity gap and duration gap to measure their exposure to interest-rate risk.

b. Explain how portfolio managers can use financial options and futures to hedge interest-rate risk.

c. Describe how portfolio managers use financial swaps to control their risk exposure. Explain how both parties in an agreement can benefit from a swap.

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This solution discusses the uses of maturity gap and duration gap to measure the exposure to interest-rate risk, hedging, and use of financial swaps.

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a. Explain how portfolio managers can use maturity gap and duration gap to measure their exposure to interest-rate risk.
Maturity Gap focuses on equity value changes and ignores cash flow timing. Portfolio managers measure the difference between a firm's weighted average asset maturity (MA) and weighted average liability maturity (ML).
Maturity Gap = (MA - ML)
MA = WA1MA1 + WA2MA2 + WA3MA3 + ... + WAnMAn
ML = WL1ML1 + WL2ML2 + WL3ML3 + ... + WLnMLn
WAi = (market value of asset i)/(market value of total assets).
WLi = (market value of liability j)/(market value of total liabilities)
MAi is the maturity of asset i.
MLi is the maturity of liability j.
Here
• When (MA - ML) > 0 then an increase (decrease) in interest rates is expected to decrease (increase) a financial firm's equity.
• When (MA - ML) < 0 then an increase (decrease) in interest rates is expected to increase (decrease) a financial firm's equity.
Equity = Assets - Liabilities
or in change form,
Δ Equity = Δ Assets - ΔLiabilities
Equity, Assets and Liabilities are measured in market value.

On the other hand Duration Gap -focuses on equity value including cash flow timing and is considered as the most complete and accurate measure of ...

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