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

A bank treasurer expects interest rates to fall sharply over the next six months and wants to increase the expected price gain on the bank's bond portfolio. Which action is most consistent with an interest rate anticipation (active) strategy?

The treasurer should lengthen portfolio duration by buying longer-maturity, low-coupon bonds. If rates are expected to fall, longer-duration bonds gain more in price, so extending duration captures the forecast. Shortening duration or holding bills would reduce the gain from the expected decline.

  1. AShorten the portfolio's average duration by moving into floating-rate notes
  2. BLengthen the portfolio's average duration by buying longer-maturity, low-coupon bondsCorrect
  3. CLadder maturities evenly across the yield curve
  4. DConcentrate holdings in short-term Treasury bills to preserve liquidity

Explanation

When rates are expected to fall, bond prices rise more for longer-duration securities. Extending duration, for example by buying long-maturity low-coupon bonds, maximises the price gain. Shortening duration or holding bills would do the opposite and lose the benefit of the forecast.

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