Free CFA Level III: Portfolio Management Liability-Driven & Index-Based Strategies Practice Questions

C is correct. Duration matching is analogous to a balanced seesaw. The liability is at one point (the fulcrum/horizon), and the portfolio's weighted average cash flow timing must balance at the same point. If interest rates change, the asset and liability values change by the same amount (like both sides of a seesaw moving equally), maintaining equilibrium.
B is incorrect because duration matching is about balance and equilibrium, not maximizing any single outcome.
A is incorrect because sector diversification is about spreading risk, while duration matching is specifically about matching the interest rate sensitivity of assets to liabilities.

C is correct. Measurement risk arises when the statistical inputs used for immunization (duration, convexity, present value calculations) are inaccurately estimated. Sources of measurement error include using approximate duration formulas, ignoring optionality in callable bonds, using incorrect yield curve models, or misestimating cash flow timing. These errors can cause the actual immunization to deviate from the intended match.
A is incorrect because the direction of rate moves is addressed by the immunization strategy itself (duration matching protects against parallel shifts). The risk of non-parallel shifts is structural risk, not measurement risk.
B is incorrect because credit rating downgrades represent credit risk, not measurement risk.

B is correct. By selecting only the most liquid bonds within each cell, the portfolio may benefit from tighter bid-ask spreads and easier execution (a form of liquidity premium advantage). However, the specific bonds chosen will differ from the index constituents, introducing security-specific tracking error. The cell-matching approach controls for the major risk dimensions (duration, credit, sector) but not for individual bond selection within cells.
Choice A is incorrect because cell matching is an approximation that will have some tracking error because it does not hold every index constituent.
Choice C is incorrect because liquidity and credit quality are not inversely related in a simple way. Within each credit quality cell, the manager selects liquid bonds of the same credit quality, so there is no systematic downgrade in credit quality.