In which investment strategy is the duration of the hedging bucket matched to the duration of the liabilities?

• A. Overlay approach
• B. Cash flow matching approach
• C. Duration matching approach
• D. Liquidity-driven investing

Answer: (C)

The duration matching approach involves aligning the duration of assets in a hedging bucket with the duration of corresponding liabilities. This strategy is particularly relevant in managing interest rate risk, ensuring that fluctuations in interest rates do not significantly impact the value of the liabilities relative to the assets.

By matching the durations, the investor seeks to minimize the impact of changes in interest rates on the liability side, thereby stabilizing the overall portfolio value. This is crucial for entities such as pension funds or insurance companies with fixed liabilities that require funding at specific future dates.

In contrast, the overlay approach focuses on using derivatives to manage risk without directly altering the underlying assets. The cash flow matching approach emphasizes aligning cash flows rather than durations, while liquidity-driven investing primarily focuses on ensuring that investments can be easily converted to cash without significant loss, with less emphasis on the duration of the liabilities. Thus, selecting the duration matching approach correctly identifies the strategy that directly addresses the alignment of asset and liability durations to effectively manage interest rate risk.