Thoughts on Leverage Adjusted Duration Gap deposits, gap, interested, adjusted, material

LBriscoe

For those who are interested I was just having a discussion with a friend re: LADG and we think we may have come up with a simple way of viewing this formula. I found the Schweser notes don't really offer any detail and I can't stand reading the dribble from the CFA material.

In simple terms a banks liabilities are its borrowings (deposits, bond issuance etc); it's assets are it's loans. The forumla measures the gap in duration b/w to the two adjusted for leverage.

The relationship states that if LADG is <0 in an environment of increasing interest rates the MV of equity increases. Looking at this intuitively, for the LADG to be less than zero the duration of the liabilities is greater than the assets. Put another way, the banks borrowings have greater price sensitivity to changes in interest rates thus an increase in rates will decrease the value of the debt, the bank has borrowed at a cheaper rate than the current market offers. The assets (loans) have a smaller duration thus this is good from the banks perspective because as they mature they can reinvest at higher rates. A - L = E. For a given increase in rates L will decrease by a relatively greater proportion than A thus increasing E.

The LADG captures this relationship. If LADG is <0 as rates are decreasing the inverse applies. Value of liabilities increase by a greater rate due to higher duration when compared to the banks assets, therefore equity decreases.