Bond Portfolio
Immunization
Introduction
An immunized bond portfolio is
largely protected from fluctuations
in market interest rates
– Seldom possible to eliminate interest rate risk
completely
– A portfolio’s immunization can wear out,
requiring managerial action to reinstate the
portfolio
– Continually immunizing a fixed-income
portfolio can be time-consuming and technical
Bond Risks
A fixed income investor faces three
primary sources of risk:
– Credit risk
– Interest rate risk
Duration is the most widely used measure
of a bond’s interest rate risk
– Reinvestment rate risk
Duration Matching
• An independent
portfolio
• Bullet immunization
example
• Expectation of
changing interest
rates
Example of Portfolio Immunization
• Assume we are interested in a $1,000 par
value bond that will mature in two years.
• The bond has a coupon rate of 8 percent and
pays $80 in interest at the end of each year.
• Interest rates on comparable bonds are also at
8 percent but may fall to as low as 6 percent or
rise as high as 10 percent.
Example cont..
The buyer knows he will receive $1000 at
maturity, but in the meantime he faces the
uncertainty of having to reinvest the annual
$80 in interest earnings at 6%, 8%, or 10%.
Example: Case 1
Let interest rates fall to 6%.
– The bond will earn $80 in interest payments for
year one, $80 for year two, and $4.80 ($80 x
0.06) when the $80 interest income received the
first year is reinvested at 6% during year 2.
Example: Case 1
• How much will the investor earn over the
two years?
– First year’s interest earnings + Second year’s
interest earnings + Interest earned reinvesting
the first year’s interest earnings at 6% + Par
value of the bond at maturity.
– $80 + $80 + $4.80 + $1,000 = $1,164.80
Example: Case 2
Let interest rates rise to 10%.
– The bond will earn $80 in interest payments for
year one, $80 for year two, and $8.00 ($80 x 0.10)
when the $80 interest income received the first
year is reinvested at 10% during year 2.
Example: Case 2
• How much will the investor earn over the
two years?
– First year’s interest earnings + Second year’s
interest earnings + Interest earned reinvesting
the first year’s interest earnings at 10% + Par
value of the bond at maturity.
– $80 + $80 + $8 + $1,000 = $1,168.00
Immunization and Duration
• The investor’s earnings could drop as low
as $1,164.80 or rise as high as $1,168.
• But, if the investor can find a bond whose
duration matches his or her planned holding
period, he or she can avoid this fluctuation
in earnings.
– The bond will have a maturity that exceeds the
investor’s holding period, but its duration will
match it.
Example: Case 1
• Let interest rates fall to 6%.
– The bond will earn $80 in interest payments for
year one, $80 for year two, and $4.80 ($80 x
0.06) when the $80 interest income received the
first year is reinvested at 6% during year 2.
– But, the bond’s market price will rise to
$1,001.60 due to the drop in interest rates.
Example: Case 1
• How much will the investor earn over the
two years?
– First year’s interest earnings + Second year’s
interest earnings + Interest earned reinvesting
the first year’s interest earnings at 6% + Market
price of the bond at the end of the investor’s
planned holding period.
– $80 + $80 + $4.80 + $1,001.60 = $1,166.40
Example: Case 2
• Let interest rates rise to 10%.
– The bond will earn $80 in interest payments for
year one, $80 for year two, and $8.00 ($80 x
0.10) when the $80 interest income received the
first year is reinvested at 10% during year 2.
– But, the bond’s market price will fall to
$998.40 due to the rise in interest rates.
Example: Case 2
• How much will the investor earn over the
two years?
– First year’s interest earnings + Second year’s
interest earnings + Interest earned reinvesting the
first year’s interest earnings at 10% + Par value
of the bond at maturity.
– $80 + $80 + $8 + $998.40 = $1,166.40
• The investor earns identical total earnings
whether interest rates go up or down.
– With duration set equal to the buyer’s planned
holding period, a fall (rise) in the reinvestment
rate is completely offset by an increase (a
decrease) in the bond’s market price.
Two versions of duration matching
1. Duration matching
• Bullet immunization &
• Bank immunization
2. Duration shifting
Bullet Immunization
• Seeks to ensure that a predetermined sum of money is available at
a specific time in the future regardless of interest rate movements
• Objective is to get the effects of interest rate and reinvestment rate
risk to offset
– If interest rates rise, coupon proceeds can be reinvested at a
higher rate
– If interest rates fall, proceeds can be reinvested at a lower rate
• (skip details on the example)
– Choose a bond with YTM=desired return and duration
matching the time you will need the money from the
investment
Bank Immunization
• Addresses the problem that occurs if
interest-sensitive liabilities are included
in the portfolio
– E.g., a bank’s portfolio manager is
concerned with the entire balance sheet
– A bank’s funds gap is the dollar value of its
interest rate sensitive assets (RSA) minus its
interest rate sensitive liabilities (RSL)
Bank Immunization
To immunize itself, a bank must reorganize its
balance sheet such that:
$ A DA $ L DL
where
$ A, L dollar value of interest sensitive assets or liabilities
DA, L dollar - weighted average duration of assets or liabilities
Effects of Bond Immunization
• Minimize adverse effects of Bond immunization
• Interest rate fluctuations also affect a bond's
reinvestment risk.
• Interest rate changes have opposite effects on a
bond's price and reinvestment opportunities.
• Portfolio duration= Investor’s time horizon
• Matches specified anticipated receipts to investors
liabilities
Disadvantages of BPI
• Opportunity Cost of Being Wrong
• Lower Yield
• Transaction Costs
• Immunization Is Instantaneous Only
Hedging With Interest Rate
Futures
•A financial institution can use futures
contracts to hedge interest rate risk
•The hedge ratio is:
Pb Db (1 YTM ctd )
HR CFctd
Pf D f (1 YTM b )
Hedging With Interest Rate
Futures (cont’d)
The number of contracts necessary is given by:
portfoliopar value
# contracts hedgeratio
$100,000
Hedging With Interest Rate
Futures (cont’d)
Futures Hedging Example
• A bank portfolio holds $10 million face value in
government bonds with a market value of $9.7 million,
and an average YTM of 7.8%. The weighted average
duration of the portfolio is 9.0 years. The cheapest to
deliver bond has a duration of 11.14 years, a YTM of
7.1%, and a CBOT correction factor of 1.1529.
An available futures contract has a market price of 90
22/32 of par, or 0.906875. What is the hedge ratio? How
many futures contracts are needed to hedge?
Hedging With Interest Rate
Futures (cont’d)
Futures Hedging Example (cont’d)
The hedge ratio is:
0.97 9.0 1.071
HR 1.1529 0.9898
0.90687511.14 1.078
Hedging With Interest Rate
Futures (cont’d)
Futures Hedging Example (cont’d)
The number of contracts needed to hedge is:
$10,000,00 0
# contracts 0.9898 98.98
$100,000