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

Which limitation most directly reduces the reliability of a duration gap measure of economic value of equity sensitivity for a bank with large holdings of mortgage-backed securities?

Embedded prepayment options make cash flows depend on interest rates, so the duration of mortgage securities shifts as rates move and negative convexity appears. A duration gap based on current duration therefore misestimates equity value changes, especially for large rate shocks.

  1. APrepayment options make asset cash flows and duration change as rates move, so duration alone mis-estimates the value change for large shiftsCorrect
  2. BDuration gap cannot be computed when liabilities exceed assets
  3. CDuration gap measures only the change in net interest income over twelve months
  4. DDuration gap requires that all assets and liabilities have the same maturity

Explanation

Embedded prepayment options create negative convexity and make cash flows rate-dependent, so a fixed duration is a poor guide for large rate moves. Duration gap measures value changes, not twelve-month income, and does not require equal maturities.

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