In finance, interest rate immunization is a strategy that ensures that a change in interest rates will not affect the value of a portfolio. Similarly, immunization can be used to ensure 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.

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.

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.

[edit] 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, 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 would exactly match its expected cash outflows, and a change in interest rates would 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.

[edit] Volatility matching

A more practical alternative immunization method is duration matching. Here, the duration of the assets is matched with the duration of the liabilities. Alternatively, the first derivative of the asset's price function with respect to the interest rate, is matched with the liabilities. To make the match more profitable, the assets and liabilities are arranged so that the convexities of the assets exceed the convexity of the liabilities; alternatively, the second derivative of the assets is set to exceed the second derivative of the liabilities.

[edit] 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 most prevalent risk factors. 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.

[edit] 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 (i.e., the issuer of a bond).

Users of this technique include banks, insurance companies, pension funds and bond brokers; individual investors infrequently have the resources to properly immunize their portfolios.

The disadvantage associated with duration matching is that it assumes the durations of assets and liabilities remain unchanged, which is rarely the case.

[edit] See also

• Arbitrage
• Asset liability mismatch
• Bond convexity
• Bond duration
• Bond (finance)
• Covered interest arbitrage
• Duration gap
• Hedging
• Interest rate parity
• Interest rate swap

[edit] External links

• Guide to Hedging Interest Rate Risk
• Basic Fixed Income Derivative Hedging Article on Financial-edu.com
• Hedging Corporate Bond Issuance with Rate Locks article on Financial-edu.com

[edit] References

• Stulz, René M. (2003). Risk Management & Derivatives (1st ed.). Mason, Ohio: Thomson South-Western. ISBN 0-538-86101-0. 

[edit] Recommended Reading

• Wesley Phoa, Advanced Fixed Income Analytics, Frank J. Fabozzi Associates, New Hope Pennsylvania, 1998. ISBN 1-883249-34-1

This article is licensed under the GNU Free Documentation License. It uses material from the Wikipedia article "Immunization (finance)".