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

A pension fund must pay a single liability of $10 million in exactly 6 years. It currently holds a portfolio of bonds with a Macaulay duration of 6 years but whose cash flows are dispersed widely, with a barbell of 1-year and 15-year bonds. Which statement best describes the residual risk of this immunization strategy?

The fund remains exposed to non-parallel yield curve shifts. Duration matching protects only against small parallel moves, and a barbell has greater dispersion and convexity than a single 6-year liability, so curve twists can leave assets worth less than the liability.

  1. AIt is exposed to non-parallel yield curve shifts because its convexity and dispersion exceed those of the liabilityCorrect
  2. BIt has no interest rate risk because durations are matched
  3. CIt is exposed only to reinvestment risk, which is eliminated by higher convexity
  4. DIt is exposed to credit risk only, since duration matching removes all interest rate risk

Explanation

Duration matching immunizes only against small parallel shifts. A barbell has higher convexity and dispersion than the single-cash-flow liability, so twists or non-parallel shifts can make the asset value fall short of the liability. Matched duration does not remove interest rate risk generally, and higher dispersion increases rather than eliminates it.

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