Duration gap
Duration gap is like a game with two teams - the bank and its customers. The bank has money from its customers that it uses to make loans to other customers. The duration gap is the difference between the time the bank has to pay back the money to its customers and the time it takes to collect money from its borrowers.
Think of it like soccer - the bank is playing offense and its customers are on defense. The bank wants to score goals by lending money to its borrowers and earning interest. But the bank needs to be careful - if it lends out money for too long, then it won't have enough money to pay back its customers if they want it back. On the other hand, if the bank lends out money for too short of a time, then it won't be able to earn as much interest.
Now let's get into the nitty-gritty. For example, let's say a bank has $100 from its customers that they want back in one year. The bank makes a loan to a borrower for two years and earns 5% interest. If the bank can't get the money back from the borrower until two years later, then it will have a duration gap of one year. This means that the bank will have to wait an extra year to pay back its customers.
But wait, there's more! The bank also needs to consider interest rate risk. If interest rates go up, then the bank's cost of borrowing (to pay back its customers) will go up, and the income it earns from lending (to its borrowers) will not go up as much. This could result in losses for the bank. On the other hand, if interest rates go down, the bank's cost of borrowing will go down, and it will be able to earn more income from lending. This could result in gains for the bank.
So, in summary, duration gap is the difference between the time the bank has to pay back its customers and the time it takes to collect money from its borrowers. It's like a game where the bank is playing offense and its customers are on defense. The bank wants to lend money for the right amount of time so it can earn interest, but it needs to be careful not to lend out too much money for too long or too short of a time.
Think of it like soccer - the bank is playing offense and its customers are on defense. The bank wants to score goals by lending money to its borrowers and earning interest. But the bank needs to be careful - if it lends out money for too long, then it won't have enough money to pay back its customers if they want it back. On the other hand, if the bank lends out money for too short of a time, then it won't be able to earn as much interest.
Now let's get into the nitty-gritty. For example, let's say a bank has $100 from its customers that they want back in one year. The bank makes a loan to a borrower for two years and earns 5% interest. If the bank can't get the money back from the borrower until two years later, then it will have a duration gap of one year. This means that the bank will have to wait an extra year to pay back its customers.
But wait, there's more! The bank also needs to consider interest rate risk. If interest rates go up, then the bank's cost of borrowing (to pay back its customers) will go up, and the income it earns from lending (to its borrowers) will not go up as much. This could result in losses for the bank. On the other hand, if interest rates go down, the bank's cost of borrowing will go down, and it will be able to earn more income from lending. This could result in gains for the bank.
So, in summary, duration gap is the difference between the time the bank has to pay back its customers and the time it takes to collect money from its borrowers. It's like a game where the bank is playing offense and its customers are on defense. The bank wants to lend money for the right amount of time so it can earn interest, but it needs to be careful not to lend out too much money for too long or too short of a time.
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