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

A risk manager notes that a bank's duration gap is positive and large. Which statement about the bank's economic value of equity (EVE) exposure under a parallel shift is correct?

With a large positive duration gap, economic value of equity falls when rates rise. Assets have greater dollar duration than liabilities, so their market value declines by more than that of liabilities, and the difference is borne by equity holders.

  1. AEVE rises when interest rates rise because liabilities reprice faster
  2. BEVE is unaffected because duration gap measures only net interest income
  3. CEVE falls when interest rates rise because asset values fall more than liability valuesCorrect
  4. DEVE falls when interest rates fall because asset cash flows are reinvested at lower rates

Explanation

A positive leverage-adjusted duration gap means the dollar duration of assets exceeds that of liabilities, so a rate rise cuts asset value by more than liability value, reducing EVE. Duration gap is a market value (economic) measure, not an earnings measure, which rules out the second option.

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