What happens if duration of assets does not equal duration of liabilities?

When the duration of assets does not equal the duration of liabilities, the primary consequence is that cash flows will be mismatched. Duration is a measure of the sensitivity of the price of a bond or a bond portfolio to changes in interest rates and represents the weighted average time until cash flows are received.

If the durations are not aligned, it implies that the timing of cash flows from assets and liabilities is not synchronized. For instance, if the assets have a longer duration than the liabilities, the organization may receive cash from its investments later than it needs to make payments for its obligations. This mismatch can lead to liquidity issues, as the organization may find itself in a position where it does not have enough readily available cash to meet its obligations as they come due.

This dynamic creates potential risks in managing the portfolio effectively, particularly if interest rates change, as it may amplify the exposure to interest rate fluctuations. Proper matching of asset and liability durations is crucial for effective cash flow management and minimizing financial risk.