What is an 'Interest Rate Gap'

An interest rate gap measures a firm's exposure to interest rate risk. The gap is the distance between assets and liabilities. The most commonly seen examples of an interest rate gap are in the banking industry. A bank borrows funds at one rate and loans the money out at a higher rate. The gap, or difference, between the two rates represents the bank's profit.

BREAKING DOWN 'Interest Rate Gap'

There are two types of interest rate gaps, fixed and variable. Each measures the difference between rates on assets and liabilities and is an indicator of interest rate risk. Determination of the differential spans a given period for both fixed and variable interest rate gaps. 

The interest rate gap shows the risk of rate exposure. Typically, financial institutions and investors use it to develop hedge positions, often through the use of interest rate futures. Gap calculations are dependent on the maturity date of the securities used, and the period remaining before the underlying securities reach maturity.

Interest rate gaps can also apply to the difference in interest rates on government securities between two different countries.

For example, a bank may borrow $100 million for 30 days at 5% interest. At the same time, the bank will loan $100 million for 60 days at 5.5%. An interest rate gap calculation would allow the bank to determine its 30v60 day forward rate.

Reasons to Track the Interest Rate Gap

Institutions that profit from interest rate differentials or funds their activities with loans must keep track of the gap. The interest rate a business pays for money is a liability. The deduction of the liability cost from the contractual, or expected rate of return on assets, must be calculated to arrive at the actual profit.

A bank, which hopes to borrow low and loan high, must be keenly aware of the yield curve. The yield curve is the difference among interest rates across the maturity spectrum. A flat yield curve indicates there is a low differential between liabilities and assets. A flat yield is harmful to profitability. In an extreme negative instance, a yield curve may become inverted. In this case, short rates are above long rates, and a loan business is entirely unprofitable.

For firms that fund large projects, such as building a new nuclear power plant, the interest rate gap lets them know how to secure funding. If they borrow in short-term maturities for a project that is of a long-term nature, they risk that the rate of continuing funding needs will rise, thereby increasing costs. A hedging strategy may be useful to reduce the risk of a sizable interest rate gap.

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