How is the adjusted duration gap calculated?

The adjusted duration gap is a key measure in finance used to assess the sensitivity of an institution's equity value to changes in interest rates. It takes into account the relationship between the durations of assets and liabilities, scaled by their relative market values. To calculate the adjusted duration gap, you start with the duration of the assets and subtract the weighted duration of liabilities.

The correct calculation method involves taking the duration of assets and subtracting the product of the market value of liabilities divided by the market value of assets and the duration of liabilities. This adjustment accounts for the proportion of each component in the overall balance sheet, ensuring that the calculation reflects the impact of changes in interest rates on the institution's net worth more accurately.

This approach captures how exposure to interest rate risk is influenced not just by the duration of the assets and liabilities, but also by their respective sizes in terms of market value. Therefore, it provides a more nuanced understanding of the risk exposure.

If the adjusted duration gap were simply the difference between the durations of assets and liabilities without the market value considerations, it could potentially misrepresent the risk profile, particularly for institutions where the sizes of the asset and liability portfolios differ significantly. Thus, the adjusted duration gap formula provides a more reliable framework for asset-liability