Immunization (Finance)

In finance, Immunization also referred to as multi-period immunization, maybe a risk-mitigation strategy that matches the duration of assets and liabilities, minimizing the impact of interest rates on net worth over time. It’s a method of investing in fetters specified the portfolio’s target return is protected against charge per unit fluctuations. Changes in returns at which cash flows are often reinvested are offset by changes within the value of the securities within the portfolio.

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 must deal with uncertain future interest rates.

To understand the immunization strategy, first remember that although bond prices fall when interest rates rise, the speed at which the investor can reinvest his coupon payments increases (the opposite is additionally true: when rates fall, prices rise but the reinvestment rate falls).

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

Rt = At – Lt for t = 1, 2, 3, . . . , n

Where At and Lt represent cash inflows and outflows or liabilities respectively.

Assuming that the present value of cash inflows from the assets is equal to the present value of the cash outflows from the liabilities, then:

P(i) = 0

Immunization helps large firms and institutions protect their portfolios from exposure to the rate of interest fluctuations. Employing a perfect immunization strategy, firms can nearly guarantee that movements in interest rates will have virtually no impact on the worth of their portfolios.

Immunization is considered a “quasi-active” risk mitigation strategy since it has the characteristics of both active and passive strategies. By definition, pure immunization implies that a portfolio is invested for a defined return for a specific period of time regardless of any outside influences, such as changes in interest rates.

A dedicated-portfolio strategy and immunization particularly is most appropriate when an investor must fund a future liability. When executed well, it can provide terrific returns (and tremendous peace of mind) to investors. But immunization isn’t without risks. It requires investors to calculate and time future liabilities, which isn’t always easy or accurate. Immunization also assumes that when interest rates change, they modify by the identical amount for all kinds of bond maturities. This, of course, rarely happens within the globe and it, therefore, makes duration matching harder. Thus, the immunization strategy doesn’t make sure the expected return when interest rates change.

The opportunity cost of using the immunization strategy is potentially giving up the upside potential of an active strategy for the assurance that the portfolio will achieve the intended desired return. As in the buy-and-hold strategy, by design, the instruments best suited for this strategy are high-grade bonds with remote possibilities of default. In fact, the purest form of immunization would be to invest in a zero-coupon bond and match the maturity of the bond to the date on which the cash flow is expected to be needed. This eliminates any variability of return, positive or negative, associated with the reinvestment of cash flows.

Immunization, if possible and complete, can protect against term mismatch but not against different kinds of monetary risk like default by the borrower (i.e., the issuer of a bond). it would even be difficult to search out assets with suitable income structures that are necessary to confirm a selected level of overall volatility of assets to possess a correct match thereupon 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.

One way to regulate immunization risk is to take a position solely in zero-coupon bonds that have maturities matching the investor’s time horizon. Portfolios with high immunization risk, on the opposite hand, include high-coupon securities that mature at regularly spaced intervals over the course of the portfolio’s time horizon (this is named laddering). This constant maturing means frequent reinvestment, which implies a high sensitivity to changes in interest rates and thus high immunization risk.

 

Information Sources:

  1. investopedia.com
  2. investinganswers.com
  3. wikipedia