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

## 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.

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