duration gap (mismatch)
Imagine balancing a long pole on your finger versus a short one. The long pole swings wildly with the slightest movement; the short one is easy to steady. Assets and liabilities are like two poles. If they have different durations, an interest-rate move tips them by different amounts and your surplus rocks back and forth. The duration gap is the simple, single-number measure of that imbalance: roughly, the duration of your assets minus the duration of your liabilities (often value-weighted).
Read the sign and you know your exposure. A positive gap means assets are longer (more rate-sensitive) than liabilities: if rates rise, assets fall more than liabilities, so surplus shrinks; if rates fall, surplus grows. A negative gap is the reverse and is the classic danger for life insurers, whose liabilities are often very long: when rates fall, long liabilities balloon faster than shorter assets, and surplus is squeezed. A zero gap means assets and liabilities move together for a small rate change — this is exactly the duration-matching condition of immunization. For example, assets with duration 5 backing liabilities with duration 9 give a gap of minus 4, a meaningful exposure to falling rates.
Why it matters: the duration gap is the dashboard light of ALM. Risk managers watch it constantly, set limits on how far it may stray from zero, and rebalance — lengthening or shortening the bond portfolio — to pull it back. The honest caveats: a zero duration gap protects only against a small, parallel shift in the whole curve, so a firm can be perfectly duration-matched and still lose money if the curve twists or rates move a lot; and the gap drifts on its own as bonds age and the curve changes, so it must be recomputed and managed continually, not set once.
Assets of duration 5 back liabilities of duration 9, a gap of minus 4. A 1 percent fall in rates lifts liabilities by roughly 9 percent but assets by only 5 percent, so surplus falls about 4 percent of the position.
The gap tells you which way a rate move will hurt — and by roughly how much.
A zero duration gap is not full safety: it only neutralizes a small parallel shift, not a twist in the curve or a large move, where convexity and scenario testing take over.