A tool that measures the mismatch between a firm’s assets and liabilities. It is a measure of the sensitivity of the value of the balance sheet to changes in market interest rates. More specifically, it is calculated as difference between the weighted duration of assets minus the product of the weighted duration of liabilities and the ratio of total liabilities to total assets:

D_Gap = D_A – D_L × L/A

Where: D_A and D_L denote the weighted durations of assets and liabilities, respectively; L and A denote the values of liabilities and assets, respectively. This formula can be rewritten as:

D_Gap = D_E × E/A

Where: D_E is the duration of equity and E is the value of equity.

A zero duration gap implies that the equity is not exposed to interest rate risk (it will not be affected by changes in interest rates). A positive duration gap tells us that the market value of equity will fall when interest rate increases (this corresponds to a refinance position). A negative duration gap means that the market value of equity will increase when interest rates rise (this corresponds to a reinvestment position).

The duration gap is usually used by financial institutions such as banks to gauge their overall exposure to interest rate risk.