If you invest in bonds, currencies or fixed securities you know that changes in interest rates can quickly turn your dreams of profit into a nightmare. Imagine being a huge investment bank with billions of dollars on the line and you can understand how losses can really pile up!
So how do these major players hedge their interest rate risk? One available strategy is interest rate immunization. (For background reading, see Advanced Bond Concepts.)
Why Do Interest Rates Matter?
Bonds and other fixed securities have two main types of risk: interest rate risk and credit risk. To measure interest rate risk, we use a concept called duration, a measure of how sensitive the price of a bond is to changes in interest rates. The longer a bond's maturity, the greater its duration and yield swings. If interest rates go up, bond prices will go down. For a portfolio of bonds, this means that increases in interest rates lower the portfolio's value.
Figure 1  
Copyright coupons are received), the present value of cash flows and the future value. However, even after analyzing countless scenarios through complex mathematical formulas, a large number of variables can react in unexpected ways. What Is Interest Rate Immunization? Interest rate immunization is a hedging strategy that seeks to limit or offset the effect that changes in interest rates can have on a portfolio or fixed security. Immunization strategies use derivatives and other financial instruments to offset as much risk as possible when it comes to interest rates. In order to immunize an investment or portfolio, you need to understand two things: duration and convexity. (For background reading, see Use Duration And Convexity To Measure Risk.) Duration and Convexity: The Basics
It can be approximated to: This shows that a bond with a duration of four years will decline in value 4% for each 1% increase in interest rates. (Remember that bond prices and interest rates move in opposite directions.) A bond with a duration of two years would decline by 2% for every 1% increase in interest rates. Thus, bonds with longer durations are more sensitive to fluctuations in interest rates. (For more on this, read Advanced Bond Concepts: Duration.) If a bond has fixed cash flow payments, the Macaulay formula for duration is used. The formula is a weighted average of the cash flows.
To calculate the duration of a bond portfolio, you can take a weighted average of each component's duration.
If a portfolio manager only pays attention to duration, the tangent line can be quite inaccurate if a bond is heavily curved either positively or negatively; in other words, the accuracy of duration modeling deteriorates with greater changes to interest rates. Portfolio managers tend to gravitate toward bonds with greater convexity. This is because the bond price will theoretically increase more as interest rates fall when compared to bonds with lower convexity.
We then take another derivative in order to expand , leaving us with: Using this formula requires you to plug in convexity and duration values that you calculate based on the bonds used in the portfolio. The bottom line is that immunization involves a complicated set of calculations. For a portfolio comprised of government securities and highgrade bonds, calculations might be relatively simple, but in today's financial environment, companies are investing in a variety of hardtograsp financial instruments, such as CDOs and junk bonds. Bonds with embedded options tend to be more volatile, which makes duration even more difficult to calculate. (To learn about junk bonds, read Junk Bonds: Everything You Need To Know.) What Type of Investor Uses This Strategy? This sort of strategy is often too complicated or too resourceintensive for the average investor. The analysis of different durations, cash flows and liabilities is complicated, and the transaction costs associated with the purchase and sale of derivatives can be prohibitive. Conclusion 

Bonds & Fixed Income
Use Duration And Convexity To Measure Bond Risk
Find out how this measure can help fixedincome investors manage their portfolios. 
Options & Futures
Top 4 Strategies For Managing A Bond Portfolio
Find out how these strategies work and how you can put them to work for you. 
Bonds & Fixed Income
Advanced Bond Concepts
Learn the complex concepts and calculations for trading bonds including bond pricing, yield, term structure of interest rates and duration. 
Home & Auto
Understanding RenttoOwn Contracts
They can work for you or against you. Here's how to negotiate a fair one. 
Mutual Funds & ETFs
Top 3 Switzerland ETFs
Explore detailed analysis and information of the top three Swiss exchangetraded funds that offer exposure to the Swiss equities market. 
Home & Auto
Avoiding the 5 Most Common RenttoOwn Mistakes
Pitfalls that a prospective tenantbuyer could encounter on the road to purchase – and how not to stumble into them. 
Home & Auto
Renting vs. Owning: Which is Better for You?
Despite the conventional wisdom, renting might make more financial sense than you think. 
Investing Basics
Explaining Options Contracts
Options contracts grant the owner the right to buy or sell shares of a security in the future at a given price. 
Home & Auto
When Are RenttoOwn Homes a Good Idea?
Lease now and pay later can work – for a select few. 
Mutual Funds & ETFs
ETF Analysis: PowerShares S&P 500 Downside Hedged
Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.

Plain Vanilla
The most basic or standard version of a financial instrument, ... 
Normal Profit
An economic condition occurring when the difference between a ... 
Theta
A measure of the rate of decline in the value of an option due ... 
Derivative
A security with a price that is dependent upon or derived from ... 
Security
A financial instrument that represents an ownership position ... 
Series 6
A securities license entitling the holder to register as a limited ...

How can I use a bond's duration to predict its return?
A bond's duration can determine its future cash flows. It measures the bond's profitability if it is held to maturity. Duration ... Read Full Answer >> 
What does the Macaulay duration indicate about a bond?
The Macaulay duration measures the present value weighted average maturity for a bond. It describes how sensitive a bond’s ... Read Full Answer >> 
Do longterm bonds have a greater interest rate risk than shortterm bonds?
The answer to this question lies in the fixed income nature of bonds and debentures, often referred to together simply as ... Read Full Answer >> 
How does a forward contract differ from a call option?
Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >> 
Why do companies enter into futures contracts?
Different types of companies may enter into futures contracts for different purposes. The most common reason is to hedge ... Read Full Answer >> 
How can I hedge my portfolio to protect from a decline in the food and beverage sector?
The food and beverage sector exhibits greater volatility than the broader market and tends to suffer largerthanaverage ... Read Full Answer >>