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

Which statement best describes a key limitation of duration-based hedging with interest rate futures?

Duration-based hedging assumes small, parallel shifts in the yield curve, so all maturities move by the same amount. Twists, large yield changes and differences between the portfolio and the futures underlying leave residual risk. It does not require matching coupons and does not remove basis risk.

  1. AIt assumes yield changes are small and the same across maturities, that is, parallel shifts of the yield curveCorrect
  2. BIt requires the hedged portfolio and the futures underlying to have identical coupon rates
  3. CIt assumes futures prices do not change when yields change
  4. DIt eliminates basis risk because duration matches the portfolio exactly

Explanation

Duration is a first-order measure that assumes small, parallel yield curve shifts. Non-parallel shifts, large moves (convexity), and differences between the portfolio and the cheapest-to-deliver bond leave residual risk. Coupons need not match, futures prices do respond to yields, and basis risk remains.

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