DEFINITION of Zero-Gap Condition

A zero-gap condition exists when a financial institution's interest rate-sensitive assets and liabilities are in perfect balance for a given maturity. The condition derives its name from the fact that the duration gap - or the difference in the sensitivity of an institution's assets and liabilities to changes in interest rates - is exactly zero. Under this condition, a change in interest rates will not create any surplus or shortfall for the company, since the firm is immunized to its interest rate risk, for a given maturity.

BREAKING DOWN Zero-Gap Condition

Financial institutions are exposed to interest rate risk when the interest rate sensitivity (also known as the duration) of their assets differs from the interest rate sensitivity of their liabilities. A zero-gap condition immunizes an institution from interest rate risk by ensuring that a change in interest rates will not affect the overall value of the firm's net worth.

Due to fluctuations in interest rates, firms and especially financial institutions face the risk of a duration gap in the interest rate sensitivities between their assets and liabilities, meaning that a 1% change in interest rates may increase the value of its assets by a lesser degree than the value gained to its liabilities, resulting in a shortfall. To mitigate such interest rate risks, firms must make sure that any change in interest rates does not affect the overall value of the net worth of the firm. This "immunization" of the firm from interest rate risks is practiced by maintaining the difference in the sensitivity of the assets and liabilities of the firm given the same maturity, which is called the zero-gap condition.

The zero-gap condition can be achieved by interest rate immunization strategies. Interest rate immunization is a hedging strategy that seeks to limit or offset the effect that changes in interest rates can have on a portfolio of fixed income securities - including the mix of various interest rate sensitive assets and liabilities on a firm's balance sheet. Immunization strategies may use derivatives and other financial instruments to offset as much risk as possible when it comes to interest rates, taking into account both the portfolio's duration and its convexity, where convexity is the change in duration as interest rates move (or the curvature of the duration). In the case of fixed-income instruments, such as bonds, immunization seeks to limit changes to the price as well as reinvestment risk.