Which of the following actions would best match the durations?

Banks duration match their assets and liabilities to manage their interest risk in their banking book. A bank has $100 million in interest rate sensitive assets and $100 million in interest rate sensitive liabilities. Currently the bank’s assets have a duration of 5 and its liabilities have a duration of 2. The asset-liability management committee of the bank is in the process of duration-matching.

Which of the following actions would best match the durations?
A . Increase the duration of liabilities by 2 and increase the duration of assets by 1.
B . Increase the duration of liabilities by 2 and decrease the duration of assets by 1.
C . Decrease the duration of liabilities by 1 and increase the duration of assets by 1.
D . Decrease the duration of liabilities by 1 and decrease the duration of assets by 1.

View Answer

Answer: B

Explanation:

To match the durations of assets and liabilities, the bank needs to adjust the durations so that they are equal. Currently, the assets have a duration of 5 and the liabilities have a duration of 2.

One way to match the durations is to increase the duration of liabilities by 2 (making it 4) and decrease the duration of assets by 1 (making it 4). This results in both the assets and liabilities having the same duration, thereby matching them.