What is 'Immunization'
For example, large banks must protect their current net worth, whereas pension funds have the obligation of payments after a number of years. These institutions are both concerned about protecting the future value of their portfolios and therefore have the problem of dealing with uncertain future interest rates.
BREAKING DOWN 'Immunization'
Large firms and institutions have the ability protect their portfolios from exposure to interest rate fluctuations by using what is known as an immunization strategy. By using a perfect immunization strategy, firms can nearly guarantee that movements in interest rates will have virtually no impact on the value of their portfolios.
Immunization can be accomplished by cash flow matching, duration matching, convexity matching, and trading forwards, futures and options on bonds. Similar strategies can be used to immunize other financial risks such as exchange rate risk.
Often investors and portfolio managers use hedging techniques to reduce specific risks. Hedging strategies are usually imperfect, but if a perfect hedging strategy is in place, it is technically an immunization strategy.
Cash Flow Matching Immunization Example
Assume an investor needs to pay a $10,000 obligation in five years. To immunize against this definite cash outflow, the investor can purchase a security that guarantees a $10,000 inflow in five years. A five-year zero-coupon bond with a redemption value of $10,000 would be suitable. By purchasing this bond, the investor matches the expected inflow and outflow of cash, and any change in interest rates would not affect his ability to pay the obligation in five years.
Duration Matching Immunization Example
To immunize a bond portfolio using the duration method, an investor must match the portfolio's duration to the investment time horizon in question. If an investor has a $10,000 obligation in five years, there are a few ways in which he can use duration matching: First, an investor can purchase a zero-coupon bond that matures in five years and equals $10,000. Second, an investor can purchase several coupon bonds that each have a five year duration and total $10,000. Third, an investor can purchase several coupon bonds that total $10,000 but have an average duration of five years when viewed together.
It is possible to make a profit using duration match. All that needs to be done is to construct a bond portfolio in a way that the portfolio's convexity is higher than the convexity of the liabilities.