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FRM Part II · FRM Exam Part II · The Investment Function in Financial Services Management

A bank expects interest rates to fall significantly over the next year and wants to maximise capital gains in its investment portfolio. Which portfolio positioning is most consistent with that view?

Lengthening average duration by moving into longer-maturity bonds is correct. When rates are expected to fall, longer-duration bonds gain the most in price, so this positioning maximises capital gains. Short bills or floating-rate notes have little price sensitivity and would forgo the expected gains.

  1. ALengthen the portfolio's average duration by shifting into longer-maturity bondsCorrect
  2. BShorten the portfolio's duration by shifting into Treasury bills
  3. CHold the portfolio entirely in floating-rate notes
  4. DBuild a short-maturity ladder to maximise reinvestment flexibility

Explanation

Bond prices rise when rates fall, and longer-duration bonds rise the most. Lengthening duration therefore maximises gains if the forecast is correct. Shortening duration or holding floaters would reduce price sensitivity and forgo gains, though it would protect if rates rose.

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