Immunization (finance)

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In finance, interest rate immunization, as developed by Frank Redington 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.

Finance Academic discipline studying businesses and investments

Finance is a field that is concerned with the allocation (investment) of assets and liabilities over space and time, often under conditions of risk or uncertainty. Finance can also be defined as the art of money management. Participants in the market aim to price assets based on their risk level, fundamental value, and their expected rate of return. Finance can be split into three sub-categories: public finance, corporate finance and personal finance.

Frank Mitchell Redington was a noted British actuary. Frank Redington was best known for his development of Immunisation Theory which specifies how a fixed income portfolio can be "immunised" against changing interest rates.

Interest rate percentage of a sum of money charged for its use

An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited or borrowed. The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, the compounding frequency, and the length of time over which it is lent, deposited or borrowed.

Contents

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.

Bond duration

In finance, the duration of a financial asset that consists of fixed cash flows, for example a bond, is the weighted average of the times until those fixed cash flows are received. When the price of an asset is considered as a function of yield, duration also measures the price sensitivity to yield, the rate of change of price with respect to yield or the percentage change in price for a parallel shift in yields.

In finance, bond convexity is a measure of the non-linear relationship of bond prices to changes in interest rates, the second derivative of the price of the bond with respect to interest rates. In general, the higher the duration, the more sensitive the bond price is to the change in interest rates. Bond convexity is one of the most basic and widely used forms of convexity in finance.

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.

Hedge (finance)

A hedge is an investment position intended to offset potential losses or gains that may be incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, gambles, many types of over-the-counter and derivative products, and futures contracts.

In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit after transaction costs. For example, an arbitrage opportunity is present when there is the opportunity to instantaneously buy something for a low price and sell it for a higher price.

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 can be difficult or expensive to achieve in practice. That meant that only institutional investors could afford it. But the latest advances in technology have relieved much of this difficulty. Dedicated portfolio theory is based on cash flow matching and is being used by personal financial advisors to construct retirement portfolios for private individuals. Withdrawals from the portfolio to pay living expenses represent the stream of expected future cash flows to be matched. Individual bonds with staggered maturities are purchased whose coupon interest payments and redemptions supply the cash flows to meet the withdrawals of the retirees.

Bond (finance) instrument of indebtedness

In finance, a bond is an instrument of indebtedness of the bond issuer to the holders. The most common types of bonds include municipal bonds and corporate bonds.

Duration matching

A more practical alternative immunization method is duration matching. Here, the duration of the assets is matched with the duration of the liabilities. To make the match actually profitable under changing interest rates, the assets and liabilities are arranged so that the total convexity of the assets exceed the convexity of the liabilities. In other words, one can match the first derivatives (with respect to interest rate) of the price functions of the assets and liabilities and make sure that the second derivative of the asset price function is set to be greater than or equal to the second derivative of the liability price function.

Calculating immunization

Immunization starts with the assumption that the yield curve is flat. It then assumes that interest rate changes are parallel shifts up or down in that yield curve. Let the net cash flow at time t be denoted by Rt, i.e.:

Rt = At - Lt ; t = 1,2,3,...,n

where At and Lt represent cash inflows (At) and outflows or liabilities (Lt)

We will assume that the present value of cash inflows from the assets is equal to the present value of the cash outlfows from the liabilities. Thus, we have:

P(i) = 0
[1]

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. [ citation needed ]

Yield curve curve showing several interest rates across different contract lengths for a similar debt contract

In finance, the yield curve is a curve showing several yields or interest rates across different contract lengths for a similar debt contract. The curve shows the relation between the interest rate and the time to maturity, known as the "term", of the debt for a given borrower in a given currency. For example, the U.S. dollar interest rates paid on U.S. Treasury securities for various maturities are closely watched by many traders, and are commonly plotted on a graph such as the one on the right which is informally called "the yield curve". More formal mathematical descriptions of this relation are often called the term structure of interest rates.

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). It might also be difficult to find assets with suitable cashflow structures that are necessary to ensure a particular level of overall volatility of assets to have a proper match with that of liabilities.

Once there is a change in interest rate, the entire portfolio has to be restructured to immunize it again. Such a process of continuous restructuring of portfolios makes immunization a costly and tedious task.

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.

History

Immunization was discovered independently by several researchers in the early 1940s and 1950s. This work was largely ignored before being re-introduced in the early 1970s, whereafter it gained popularity. See Dedicated Portfolio Theory#History for details.

See also

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References

  1. The Theory of Interest, Stephen G. Kellison, McGraw Hill International,2009