What effect do changing interest rates have on the durations of assets compared to liabilities?

Changing interest rates have a greater impact on the duration of assets compared to liabilities due to fundamental differences in their cash flow characteristics. Duration is a measure of the sensitivity of the price of a financial asset to changes in interest rates, capturing the weighted average time until cash flows are received.

Assets typically have longer durations because they often involve cash flows that occur over many years, such as fixed income securities like bonds or loans. As interest rates rise, the present value of these future cash flows decreases significantly, resulting in a more pronounced change in the duration of the asset.

Liabilities, on the other hand, might include shorter-term obligations, such as payables or short-term debt, which tend to have cash flows that occur sooner and face less price sensitivity in response to interest rate changes. Consequently, the effect of interest rate changes on liabilities is comparatively muted because they are usually structured to be paid back in shorter durations.

This mismatch between the durations of assets and liabilities can lead to significant interest rate risk for financial institutions and investors, especially when assessing overall portfolio duration risk. Understanding that duration shifts more for assets enables better asset-liability management strategies.