STATIC VERSUS DYNAMIC GAPS
A dynamic gap will factor in the projections of new business and model the behavior of the balance sheet according to commercial projections. Obviously, the magnitude and signs of interest rate gap would change. Such projections remain useful for hedging, since we can set up hedges according to projected dynamic gaps rather than static gaps. Note, however, that future transactions have an unknown rate as of today, whether they are fixed or variable rates. Future fixed rate loans will earn an interest that depends on future market rates, and they should be considered as variable rate assets as of today. New liabilities would also carry an unknown rate as of today. Therefore, new transactions affect the magnitude of the variable rate gap, not that of the fixed rate gap.
Such projections requires many inputs and introduce business risk, which is the risk attached to new business. Simulations or business scenarios become more appropriate to consider both interest rate risk and business risk, as explained in the simulation chapter (Chapter 24). Often, balance sheet projections are used for budgeting purposes primarily because the budget depends on the new business that accrues over the next years. For this reason, we concentrate in what follows on static gaps and we deal with business risk and scenarios in Chapter 26.
LIMITATIONS OF INTEREST RATE GAPS
There are several limitations to interest rate gaps. However, gap reports remain common and regulations make it mandatory to monitor gaps and to specify all assumptions underlying the calculations.
Embedded Options in Banking Products
A severe limitation of interest rate gaps is due to options embedded in banking products. Such options embedded in banking products include floating rate loans that have a cap on the interest paid by the client. This is an explicit option. Others are implicit options, notably the ability of a client to renegotiate the fixed rate of their loans when interest rates decline. In such a case, the bank can charge a penalty. In competitive environments, banks tend to comply with the clients' requests because they are reluctant to give up the revenues from other products sold to the clients.
Embedded options, whether explicit or implicit, change the nature of interest rates. For example, if a rate hits a cap, the rate, which was previously variable, becomes fixed. When renegotiating the rate of a fixed rate loan, the rate was initially fixed and becomes variable. Since interest rate gaps are based on the nature of rates, they do not account for changes of variable to fixed rates and vice versa. Optional risk is discussed in Chapters 25 and 27.