What it means
The trading version of gap risk is the reason a stop-loss order is not a guarantee. If a market closes at $40 and reopens at $28 after overnight news, an order set at $37 executes near $28, and the loss is far larger than the trader planned for.
This risk concentrates around known events and around market closures. Earnings dates, central bank meetings, elections and weekends all create windows where information accumulates while trading is impossible, so exposure carried through those windows carries a fatter tail than the daily volatility figures suggest.
The banking version is a different mechanism with the same name. A bank funds long-dated loans with short-dated deposits, so when rates move, the liabilities reprice sooner than the assets and net interest income shifts, sometimes sharply.
Measuring it is a matter of bucketing. Assets and liabilities are sorted by the date on which their rate can reset, and the difference within each time band is the repricing gap for that band.
A negative gap means more liabilities reprice than assets, which hurts when rates rise and helps when they fall. Managing gap risk is rarely about eliminating it.
Traders reduce position size, use options rather than stops, or avoid holding through known events, while banks use interest rate swaps, deposit pricing and loan mix to keep the gap inside a board-approved tolerance.
In practice
Real-world examples.
Example
A hedge fund holds a short position in a biotechnology stock through a regulatory decision date. The approval comes at 7am, the stock opens 60% higher, and the fund's stop order fills far above its intended exit, turning a planned small loss into a substantial one.
Example
A regional bank enters a rate-rising cycle with a heavily negative twelve month repricing gap. Deposit costs climb within two quarters while its fixed rate mortgage book keeps earning the old rate, and net interest margin compresses for four consecutive quarters.
Example
A commodities trader avoids carrying positions over long public holidays because the exchange is closed while physical markets and overseas venues keep moving. The policy costs a little in missed opportunity but removes the largest single source of gap risk in the book.
Formula
Calculation
Repricing gap = rate-sensitive assets - rate-sensitive liabilities in a given time bucket
Change in net interest income = repricing gap x change in interest rate
A community bank reviews its zero to twelve month bucket. It has $480 million of rate-sensitive assets, mostly variable rate business loans, and $620 million of rate-sensitive liabilities, mostly short-term deposits and certificates maturing within the year.
Repricing gap = $480 million - $620 million = -$140 million
Gap ratio = $480 million / $620 million = 0.77
The bank is liability sensitive. If rates rise by 1.5% over the next year:
Change in net interest income = -$140 million x 0.015 = -$2.1 million
If instead rates fall by 1.0%:
Change in net interest income = -$140 million x -0.01 = +$1.4 million
So a rate rise of 1.5% costs the bank $2.1 million of annual earnings from this bucket alone. The treasury team can shrink that exposure by paying fixed on an interest rate swap, by lengthening deposit terms, or by writing more fixed rate lending.Case study
Seen in the real world.
Harbourstone Mutual Bank is a fictional institution used here purely to illustrate repricing gap risk. It had grown quickly by writing ten year fixed rate commercial mortgages funded largely by instant access savings accounts, a combination that looked profitable while rates were low and stable.
The asset and liability committee measured a twelve month repricing gap of roughly negative $200 million against a $900 million balance sheet. When policy rates moved up by 2% over eighteen months, savings rates followed almost immediately while the mortgage book did not reprice at all, and net interest income fell by close to $4 million a year against plan.
In the illustrative recovery, the bank paid fixed on $150 million of interest rate swaps, introduced fixed-term savings bonds to lengthen its funding, and set a board limit on the twelve month gap as a percentage of total assets. The exposure did not vanish, but it became a deliberate, sized position rather than an accident of product mix.
Watch out
Common mistakes.
- Relying on a stop-loss order as a hard floor on losses. A stop converts to a market order once triggered and fills wherever the market reopens, which may be far below your level.
- Sizing positions from average daily volatility alone. Gap risk lives in the tail, and event-driven jumps are much larger than typical daily ranges imply.
- Reading a small repricing gap as evidence of low interest rate risk. Basis risk, optionality such as early repayment, and behaviour in non-maturity deposits all sit outside a simple gap table.
Questions
People also ask.
How do traders protect against gap risk?
Mainly by reducing size before known events, using options where the maximum loss is the premium, or using guaranteed stop orders where a broker offers them for a fee.
Is a positive repricing gap always better?
No, an asset sensitive position gains when rates rise but loses when they fall, so the right gap depends on the rate outlook and the bank's tolerance for earnings swings.
Does diversification remove gap risk?
It reduces single-name exposure but not much else, because the events that cause gaps, such as macro announcements, tend to move many positions in the same direction at once.
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