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FRM Part I · FRM Exam Part I · Applying Duration, Convexity, and DV01

A risk manager hedges a bond portfolio by matching the modified duration of assets and liabilities. Which limitation of duration most directly explains why the hedge may still produce losses?

The key limitation is that duration assumes a parallel shift in the yield curve. When rates at different maturities move by different amounts, such as a twist or steepening, a duration-matched hedge can still lose money because the cash flow timing of assets and liabilities differs.

  1. ADuration assumes the yield curve moves in a parallel fashion, so twists or steepening can change values differentlyCorrect
  2. BDuration is only defined for bonds that pay no coupons, so coupon bonds are mismeasured
  3. CDuration ignores the time value of money in the bond's cash flows
  4. DDuration cannot be calculated for portfolios, only for individual securities

Explanation

Duration measures sensitivity to a single yield change, equivalent to a parallel shift. If short and long rates move by different amounts, portfolios with equal duration but different cash flow timing can change in value differently. The other statements are false: duration handles coupons, uses discounting, and is additive across a portfolio on a value-weighted basis.

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