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In finance, interest rate immunization is a strategy that insures that a change in interest rates will not affect the value of a portfolio. Similarly, immunization can be used to insure that the value of a pension fund's or a firm's assets will increase or decrease in exactly the opposite amount of their liabilities, thus leaving the value of the pension fund's surplus or firm's equity unchanged, regardless of changes in the interest rate. Finance studies and addresses the ways in which individuals, businesses, and organizations raise, allocate, and use monetary resources over time, taking into account the risks entailed in their projects. ...
Interest rate immunization can be accomplished by several methods, including cash flow matching, duration matching, and volatility and convexity matching. It can also be accomplished by trading in bond forwards, futures, or options. This article is a substub, the first step on the way to becoming a full article. ...
A duration is an amount of time or a particular time interval. ...
In finance, convexity is a measure of the sensitivity of the price of a bond to changes in interest rates. ...
Other types of financial risks, such as foreign exchange risk or stock market risk, can be immunized using similar strategies. If the immunization is incomplete, these strategies are usually called hedging. If the immunization is complete, these strategies are usually called arbitrage. It has been suggested that this article or section be merged into Hedge (finance). ...
In economics, arbitrage is the practice of taking advantage of a price differential between two or more markets: a combination of matching deals are struck that capitalize upon the imbalance, the profit being the difference between the market prices. ...
Cash flow matching
Conceptually, the easiest form of immunization is cash flow matching. For example, if a financial company is obliged to pay 100 dollars to someone in 10 years, then it can protect itself by buying and holding a 10 year zero coupon bond that matures in 10 years and has a redemption value of $100. Thus the firm's expected cash inflows exactly match its expected cash outflows, and a change in interest rates will not affect the firm's ability to pay its obligations. Nevertheless, a firm with many expected cash flows can find that cash flow matching is difficult or expensive to achieve in practice. This article is a substub, the first step on the way to becoming a full article. ...
Volatility matching A more practical alternative immunization method is duration matching. Here the duration of the assets, or first derivative of the asset's price function with respect to the interest rate, is matched with the duration of the liabilities. To make the match more accurate, the convexity or second derivative of the assets and libilities, can also be matched. In economics and finance, duration is the weighted average maturity of a bonds cash flows or of any series of linked cash flows. ...
In finance, convexity is a measure of the sensitivity of the price of a bond to changes in interest rates. ...
Immunization in practice Immunization can be done in a portfolio of a single asset type, such as government bonds, by creating long and short positions along the yield curve. It is usually possible to immunize a portfolio against the risk factors that are most prevalent. A principal component analysis of changes along the U.S. Government Treasury yield curve reveals that more than 90% of the yield curve shifts are parallel shifts, followed by a smaller percentage of slope shifts, and a very small percentage of curvature shifts. Using that knowledge, an immunized portfolio can be created by creating long positions with durations at the long and short end of the curve, and a matching short position with a duration in the middle of the curve. These positions protect against parallel shifts and slope changes, in exchange for exposure to curvature changes.
Difficulties Immunization, if possible and complete, can protect against term mismatch but not against other kinds of financial risk such as default by the borrower (of a bond). In finance, default occurs when a debtor has not met its legal obligations according to the debt contract, e. ...
In finance, a bond is a debt security, in which the issuer owes the holders a debt and is obliged to repay the principal and interest (the coupon) at a later date, termed maturity. ...
Users of this technique include banks, insurance companies, pension funds, and bond brokers.
The disadvantage associated with duration match is it assumes the duration of assets and liabilities are unchanged which is not the truth.
See also In economics, arbitrage is the practice of taking advantage of a price differential between two or more markets: a combination of matching deals are struck that capitalize upon the imbalance, the profit being the difference between the market prices. ...
In finance, convexity is a measure of the sensitivity of the price of a bond to changes in interest rates. ...
In economics and finance, duration is the weighted average maturity of a bonds cash flows or of any series of linked cash flows. ...
In finance, a bond is a debt security, in which the issuer owes the holders a debt and is obliged to repay the principal and interest (the coupon) at a later date, termed maturity. ...
Covered interest arbitrage is the investment strategy where an investor buys a financial instrument denominated in a foreign currency, and hedges his foreign exchange risk by selling a forward contract in the amount of the proceeds of the investment back into his base currency. ...
The duration gap is the difference between the duration of assets and liabilities. ...
It has been suggested that this article or section be merged into Hedge (finance). ...
It has been suggested that this article or section be merged with Spot-future parity. ...
Recommended reading - Wesley Phoa, Advanced Fixed Income Analytics, Frank J. Fabozzi Associates, New Hope Pennsylvania, 1998. ISBN 1-883249-34-1
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