By duration matching, that is creating a zero duration gap, the firm becomes "immunized" against interest rate risk. Duration has a double-facet view. It can be beneficial or harmful depending on where interest rates are headed.
When the duration of assets is larger than the duration of liabilities, the duration gap is positive. In this situation, if interest rates rise, assets will lose more value than liabilities, thus reducing the value of the firm's equity. If interest rates fall, assets will gain more value than liabilities, thus increasing the value of the firm's equity.
Conversely, when the duration of assets is less than the duration of liabilities, the duration gap is negative. If interest rates rise, liabilities will lose more value than assets, thus increasing the value of the firm's equity. If interest rates decline, liabilities will gain more value than assets, thus decreasing the value of the firm's equity.
A formula sometimes applied is:
Implied here is that even if the duration gap is zero, the firm is immunized only if the size of the liabilities equals the size of the assets. Thus as an example, with a two-year loan of one million and a one-year asset of two millions, the firm is still exposed to rollover risk after one year when the remaining year of the two-year loan has to be financed.
Further limitations of the duration gap approach to risk-management include the following:
the difficulty in finding assets and liabilities of the same duration
some assets and liabilities may have patterns of cash flows that are not well defined
