Explanation

Let's analyze each option:

A. Cash-flow mapping groups cash flows into buckets based on their size.

• ❌ Incorrect. Cash-flow mapping groups cash flows into buckets based on their maturity dates, not their size. The mapping is done according to time periods (e.g., 0-1 year, 1-3 years, etc.).

B. Cash-flow mapping uses the average rates in each risk group as a discount factor.

• ❌ Incorrect. Cash-flow mapping uses the actual cash flows and discounts them using the appropriate zero-coupon rates for each maturity, not average rates.

C. Principal mapping incorporates correlations among zero-coupon bonds.

• ❌ Incorrect. Principal mapping is the simplest approach that treats the entire portfolio as a single zero-coupon bond with maturity equal to the portfolio's maturity. It does not incorporate correlations.

D. Duration mapping replaces the portfolio with a zero-coupon bond with maturity equal to the duration of the portfolio.

• ✅ Correct. Duration mapping is a more sophisticated approach than principal mapping. It represents the portfolio as a single zero-coupon bond with maturity equal to the portfolio's duration (not maturity). This approach better captures the portfolio's interest rate sensitivity.

Key Differences:

• Principal mapping: Uses portfolio maturity
• Duration mapping: Uses portfolio duration (more accurate for interest rate risk)
• Cash-flow mapping: Most detailed - maps individual cash flows to specific maturity buckets

The correct answer is D because duration mapping indeed replaces the portfolio with a zero-coupon bond having maturity equal to the portfolio's duration, which better reflects the portfolio's interest rate sensitivity compared to principal mapping.