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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 manager immunizes a bond portfolio using modified duration alone. Which assumption about the yield curve underlies this approach and is the main reason the hedge can fail?

Duration-based hedging assumes a parallel shift, meaning all maturities' yields change by the same amount. When the curve steepens, flattens or twists, cash flows at different maturities are affected differently, so the duration-matched hedge can leave residual interest rate risk.

  1. AYields on all maturities change by the same amount (a parallel shift)Correct
  2. BShort-term rates move more than long-term rates
  3. CThe yield curve is always upward sloping
  4. DYield changes are large and nonlinear

Explanation

Duration measures price sensitivity to a single yield change applied equally to all cash flows, so it implicitly assumes a parallel shift. If the curve twists or steepens, the hedge can fail. Large moves are a convexity issue, not the underlying assumption.

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