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

A portfolio manager hedges a liability due in 10 years using a barbell of 2-year and 30-year bonds whose weighted duration equals 10 years. Which scenario poses the greatest risk to this immunization?

A steepening or flattening of the curve is the greatest risk. Duration matching assumes parallel shifts, and a barbell of 2-year and 30-year bonds has widely dispersed cash flows, so unequal short and long rate moves break the hedge of the 10-year liability.

  1. AA parallel upward shift in the yield curve
  2. BA parallel downward shift in the yield curve
  3. CA steepening or flattening of the curve, where short and long rates move by different amountsCorrect
  4. DA small uniform change in coupon payment frequency

Explanation

Duration assumes parallel shifts. A barbell has high dispersion of cash flows, so a twist in the curve changes the 2-year and 30-year values differently and breaks the match with the 10-year liability. A parallel shift is what duration handles best.

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