A duration gap is a term used to describe the difference or gap that exists between assets and liabilities held by a financial or business entity. One of the more common examples of this type of gap has to do with the difference between the influx of cash within a given period in comparison to the outflow of cash to cover pending debts. The general idea is to assess the impact of changes in interest rates and other factors over a specified time period or duration that affect the value of those assets and liabilities, with those changes either narrowing or widening the duration gap.
The goal in most cases is to function with a gap that is narrow as possible. At times, the assessment may demonstrate that the duration of assets is considerably higher than the liability durations. When this is the case, the company is considered to be in an enviable financial position, since this situation indicates that more assets are flowing in than cash is flowing out. By the same token, if the gap is wider, that indicates that the influx of cash is either barely covering the outflow or may even be insufficient to meet obligations in a timely manner, requiring the business to either borrow funds or liquidate an asset to cover the shortfall.
Determining the duration gap will often require paying close attention to the rise and fall of interest rates, and the impact those changes have on the assets and liabilities held by the company. Institutions such as banks rely heavily on the activity of interest rates to generate revenue. Should interest rates fall, this means that the flow of income will decrease, even though liabilities remain at the same levels. When interest rates rise, there is a good chance that the flow of income will increase, helping to narrow the duration gap between assets and liabilities for a given period of time.
Balancing assets and liabilities in order to avoid a possible asset liability mismatch and maintain a more or less stable gap can be difficult. In addition, some assets will be more susceptible to changes in interest rates and the general economy than others, something that may or may not be easily forecast. Even factors such as early payoffs from customers may complicate the process of determining the duration gap to some extent, since this effectively adds cash flow to a current period but removes anticipated cash flow from a later period. For these reasons, many institutions constantly reevaluate the duration gap as a means of assessing the stability of their current financial situations.