Immunization
Candlefocus EditorInterest rates form the cornerstone of the financial world. When interest rates change, different investments respond differently, and many people and businesses hold investments spread across a variety of markets. Immunization is a way to ensure that the money invested stays as safe as it can be.
Immunization involves actively managing a portfolio so that it is never exposed to worsening levels of risk, and so that any positive or negative changes in interest rate directly impacts the portfolio’s value without amplifying or dampening the effect. This is done by matching the asset and liability durations; cash flow matching; duration matching; convexity matching; and trading forwards, futures, and options on bonds.
In the case of cash-flow matching, it is possible to use cash flows from the portfolio to pay for liabilities. For instance, if a portfolio has an asset with a six-month maturity, and liabilities of the same amount at one year, it may be possible to use the cash flows from the portfolio to purchase more assets at an appropriate maturity of around a year. The result is a net portfolio value that maintains itself despite changes in interest rates.
In the case of duration matching, a portfolio may hold assets with maturities that match the liabilities of the portfolio. Alternatively, a portfolio may hold assets that have maturities that are slightly longer or shorter than the liabilities, allowing for an increase or decrease in value with a small change in interest rates.
Also, using convexity matching, investors may adjust the assets within their portfolio so that the assets respond in a similar manner to the liabilities while still maintaining its value in response to changing interest rates. This is achieved by creating assets that have similar “convexity” profiles to the liabilities, which should allow a portfolio to remain relatively stable even when there are changes in the interest rates.
Finally, trading forwards, futures, and options on bonds provides investors with an additional level of immunization. By trading instruments with similar terms and maturities, investors can adjust their positions in response to changing interest rates without risking all of their capital.
The downside of immunizing a portfolio is that by minimizing interest rate risk, the portfolio may not be able to take full advantage of potential gains in asset values while liabilities remain stationary. This missed potential is the trade-off investors have to make when they decide to immunize their portfolios.
In the end, immunization is a valuable tool that should be used with caution. Aside from potentially limiting gains, it is also possible to incur losses due to the protective measures investors put in place. To ensure success, investors should remain aware of the risks associated with immunizing a portfolio and make sure that the cost of insuring against changes in interest rates does not exceed the benefits.