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.
|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 high-grade bonds, calculations might be relatively simple, but in today's financial environment, companies are investing in a variety of hard-to-grasp 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 resource-intensive 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.