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FRM Part II · FRM Exam Part II · Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques

A bank has a positive duration gap: asset duration exceeds liability duration weighted by leverage. Management expects market yields to rise sharply. Which action using derivatives would best reduce the bank's exposure to the expected move?

The bank should enter a pay-fixed, receive-floating swap. With a positive duration gap, rising yields reduce equity value; the pay-fixed swap increases in value when rates rise and so offsets the loss. Receive-fixed swaps or long bond futures would lengthen duration and increase the exposure.

  1. AEnter a pay-fixed, receive-floating interest rate swapCorrect
  2. BEnter a receive-fixed, pay-floating interest rate swap
  3. CBuy Treasury bond futures
  4. DSell interest rate caps

Explanation

A positive duration gap means equity value falls when yields rise. A pay-fixed swap gains value when rates rise, offsetting the loss, and it effectively shortens asset duration. Receive-fixed swaps and long bond futures add duration, worsening the exposure. Selling caps adds short optionality exposure to rising rates.

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