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Zero-Gap Condition

Candlefocus Editor
A zero-gap condition helps a financial institution maintain its balance sheet, minimising the risk of unexpected losses. It minimises the interests rate risks associated with long-term liabilities. Banks and pension funds are often required to maintain a zero-gap condition in order to meet their financial obligations. Without a zero-gap condition, the two sets of cash flows from assets and liabilities might not reach the same value, as the changes in interest rates could render one or the other short or surplus (respectively).

In order to achieve a zero-gap condition, financial institutions must actively monitor their assets and liabilities and alter their portfolio mixes as needed. Asset portfolios should typically include options for a variety of maturities, such as short-term, medium-term, and long-term investments. Pension funds must match their liabilities to these assets, choosing bonds and other debt instruments with maturities that will match their liabilities. If the cash flows of these assets and liabilities are perfectly matched, then the interest rate risk associated with the duration gap can be eliminated.

The key to zero-gap condition is active portfolio management. Financial institutions should reassess the maturity of their portfolio frequently, as well as the composition of their assets and liabilities. Institutions should also be aware of the changing nature of their obligations and liabilities and the various market trends that could affect the value of their holdings. By closely monitoring their portfolios and making the necessary adjustments, institutions can achieve a zero-gap condition and protect their current net worth and future values.

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