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FRM Part I · FRM Exam Part I · Interest Rate Futures

Which of the following is a key limitation of duration-based hedging with interest rate futures?

Its key limitation is the assumption that yields shift in parallel and by equal amounts for the portfolio and the futures. Twists in the yield curve or differing yield moves leave residual risk, so the hedge is imperfect despite matching duration exposure.

  1. AIt assumes yield changes on the hedged bonds and the futures are parallel and equal, so non-parallel curve shifts leave residual riskCorrect
  2. BIt can only be used to hedge a long bond position, not a short one
  3. CIt eliminates basis risk because futures prices converge to bond prices
  4. DIt requires the futures and the hedged portfolio to have identical maturities

Explanation

Duration-based hedge ratios rely on small, parallel shifts in yields, so twists or differing moves between the hedged bonds and the futures' cheapest-to-deliver bond leave residual risk. The method works for either direction by flipping the sign. Basis risk is not eliminated, and identical maturities are not needed since duration is adjusted.

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