In times, when

internationalization of financial system increases and the pressure of

competition rises, banks will be obligated to find an equilibrium between a

prudent and balanced term structure of assets and liabilities, while pursuing

higher levels of profitability (BCBS, 2010). Due to the increase of volatility

of interest rates in present society, bank managers become more concerned about

the exposure to interest rate risk (Mishkin and Eakins 2009). The interest rate risk is a risk, which can

make a change in the value of an investment. These changes mostly affect

securities inversely and one of the things that can reduce this is investing in

fixed-income securities with different durations. Potential increases in market

interest rates in a risk to the value of fixed-income securities. When market

interest rates increase, prices for previously issued fixed-income securities

as traded in the market drop. Interest rates also affect the price sensitivity,

where prices on securities are more sensitive to increase in market interest

rates, which result in a sharp decline in their security values. To measure interest-rate risk, and fulfill

the function for banks is duration gap analysis, which examines the sensitivity

of the market value of the financial institution’s net worth to changes in

interest rates. Generally, Duration is

a measure of the sensitivity of the price -the value of principal – of a

fixed-income investment to a change in interest rates. (Investopedia).

According to Investopedia, the duration is expressed as a number of years.

Accordingly, a rise in interest rates can indicate the bond prices to fall,

while declining interest rates indicate bond prices to rise.

Duration as a concept is very useful for

banks and company’s even though it is a very complicated concept. A benefit of

using a duration analysis is that it provides a single number, which tells the

bank their overall exposure to interest rate risk. Duration is a measurement that can be used

for the project to indicate when the total of the project value will be

captured, it also captures both the time value of money and the whole of the

cash flows of a project. Projects with

higher durations carry more risk than projects with lower

durations(Kaplan). According to Mishkin,

the Duration is a useful concept, because it provides a good approximation,

examines the sensitivity of the market value of the financial institution’s net

worth to changes in interest rates using the following formula :

After calculating the

duration for each assets and liabilities on the bank’s balance sheet, the

manager of the bank could use this formula in order to calculate the changes of

the market value of each asset and liability where there is a change in interest

rates and then it can calculate the effect of net worth.As was mention duration

gap analysis analyze the sensitivity of the market value of the financial

institution’s net worth to changes in interest rates.There is another way to

find the answer by calculating the duration gap