READING 22 – Fixed Income Portfolio Management – Q23 (Source: CFAI)

@alta12, just adding to @RaviVooda‌ ‘s explanation: this question is testing to your understanding of duration gap and our need to understanding the impact on asset and liability.

This is especially relevant for pension funds as their goal is to minimize asset liability mismatch and more importantly not get into deficit ( pension asset< pension liability). Pension funds have the classic problem of trying to match SHORT TERM asset returns with LONG TERM liability. In this case, asset duration is less than liability's duration - meaning that changes in interest rates affect liability more than assets. So the worst thing to happen to EPF is if the long term interest rates go DOWN (increasing LT liability) and short term interest rates go UP (reducing asset value), I.e. flattening of the yield curve ==> deficit increases significantly.

Hope this is clear! Let us know if you have further questions!

@Alta12, In flattening when the long term interest rates come down, the liabilities go up drastically than the short term ones because of its higher duration there by creating a larger mismatch between assets and liabilities. Hence manager should be more concerned here.

In steepening, where short term interest rates are going down, causes the assets values to go up, there by decreasing gap between assets and liabilities which manager will be happy about.

Hope this helps.