EOC Reading 25 Fixed Income Part 2

[asalman07]

So Question 23 asks if there is a mismatch in duration between the benchmark and portfolio, 5.6 vs 10.2 respectively what should the manager be most conerned about?

A. flattening of the yield curve

B. Steepening of the yield curve

C. Large parallel shift up in the yield curve

Why is the answer A? If the portfolio has more duration than the benchmark shouldn’t the manager be concerned about having a further risk in duration?

In other words, if rates go up duration would increase and wouldn’t that be more of a concern? I am having a hard time here.

The answer says: A is correct. Given the mismatch in the liability and the benchmark they are running against, a flattening of the yield curve would cause the liability to increase faster than the asset.

Thanks

[cpk123]

http://www.analystforum.com/forums/cfa-forums/cfa-level-iii-forum/91319499

@S2000Magician

The correct answer cannot be a parallel upward shift; the value of the assets would decline by about 6.2 times the shift while the value of the liabilities would decline by about 10.2 times the shift; that’s a good thing.

To decide between a flattening or steepening yield curve it would be helpful to know the average maturity of the assets and liabilities. As we don’t know those numbers, we have to make the reasonable assumption that the average marturity of the liabilities is greater than the average maturity of the assets (to account for the duration difference). Given that, flattening is bad - the shorter-maturity assets will drop in value while the longer-maturity liabilities would increase in value - and steepening is good - the shorter-maturity assets will increase in value while the longer-maturity liabilities will decrease in value.

So they should be concerned about a flattening of the yield curve.

[asalman07]

thanks i should have searched, my bad.