Immunization

[edmundkan]

I have the following wordings from your 2008 study notes which is also examable in 2009 but do not understand.

Immunization
In most cases, a hedge with key rate or bucket exposures is going to be imperfect; i.e., some interest rate risk will remain. A fully immunized position would perfectly hedge each and every cash flow.

What is "immunization" means and how it is related to key rate exposure and the hedge of cash flow?

Thanks

 

[David Harper CFA FRM]

Hi Edmund

Great point, while it does find an AIM (it is "examable" as you say), in my opinion, the topic of immunization is not *really* covered in Tuckman or elsewhere in the assignments.

I find the best definition in Fabozzi (FI, 2nd, unassigned):
"Classical immunization can be defined as the process by which a bond portfolio is created to have an assured return for a specific time horizon irrespective of interest rate changes. The fundamental principle underlying immunization is to structure a portfolio that balances the change in the value of the portfolio at the end of the investment horizon with the return from the reinvestment of portfolio cash fows (both coupon and principal payments). That is, immunization offsets interest rate risk and reinvestment risk."

So, the classic example is a pension fund (or life insurance) with future cash flow obligations (payouts) that it funds with, say, bond investments. (Perfect) immunization refers to ensuring the investment returns fund the pattern of liabilities. So, importantly, as above, it refers to a successful hedge against both interest rate and reinvestment (of interim coupons) risk.

Tuckman's point is that a single factor (duration) or multi factor (key rate shift) cannot perfectly hedge. We know this is especially true of the single factor linear approximation that is duration; but a hedge based on key rates, while an improvement, is still going to show up a basis under real curve changes:

"The principles underlying hedging with key rate or bucket exposures can be extrapolated to a process known as immunization. No matter how many sources of interest rate risk are hedged, some interest rate risk remains unless the exposure to each and every cash flow has been perfectly hedged. For example, an insurance company may, by using actuarial tables, be able to predict its future liabilities relatively accurately. It can then immunize itself to interest rate risk by holding a portfolio of assets with cash flows that exactly offset the company’s future expected liabilities."

David

 

[edmundkan]

Dear David,

So is it mean that "immunization" equals "hedging"?

Thanks

 

[David Harper CFA FRM]

Hi Edmund,

Yes, but i would follow Fabozzi's implication and say that it means specifically to hedge reinvestment risk. The "immunization risk" is that the portfolio (asset) returns will not exactly fund the liabilities (e.g., pension fund liabilities). Tuckman makes a key point that the realized return will not be the yield unless the coupons are reinvested at the yield (the desire to immunize is due to the uncertaintly about future yields); to immunize is to hedge against this specific reinvestment risk. Put another way, we can eliminate the reinvestment risk by purchasing a zero coupon bond for each cash flow liability: no reinvesment risk and "perfect immunization."

David