Tuesday, 23 February 2010
Immunizing Bond Porfolios
Fabozzi Chapter 19 talks about immunization of bond portfolios, i.e. hedging out the interest rate risk and the reinvestment risk. Matching durations for bonds of different maturities exposes you to reinvestment risk (the risk that you cannot invest the coupons at the IRR). A passive strategy is one that does not require rebalancing.
The Intuition Behind Bond Immunization
The concept of "immunising" a portfolio to changes in interest rates is core to bond portfolio management and asset-liability management in banks.
Immunization, also known as multiperiod immunization, can be described in different ways in different books.
One purported goal of immunization is to minimise the reinvestment risk (the ability to reinvest coupons at the IRR). Reinvestment risk is one of the major risks of the bond (together with interest rate risk, slightly different idea, basically if you are long the bond, you face the risk of rates rising sharply).
Fabozzi Chapter 19 talks about classical immunization is creating a bond portfolio to have a fixed return for a specific time horizon, no matter what happens to interest rates (i.e. you're hedging out the interest rate risk and reinvestment risk).
Duration matching means finding a bond of same duration as your portfolio to zero out the interest rate risk. If you have a 5 year liability and hedge with a 4 year liability you are exposed to reinvestment risk.
Active strategies are those that require rebalancing. Why so? Because the duration of the portfolio keeps changing with rates. It is not a linear function of time. The portfolio and the hedge (if we divide it into two parts) get out of step in terms of duration - the durations no longer match. How often should you rebalance is an open question.
"Classical" techniques of immunization assume parallel shifts in the yield curve. Vasicek and Fong (Journal of Finance article, 1984) established a measure for immunization risk versus arbitrary rate changes.
minimising immunization risk == minimizing reinvestment risk
Immunization, also known as multiperiod immunization, can be described in different ways in different books.
One purported goal of immunization is to minimise the reinvestment risk (the ability to reinvest coupons at the IRR). Reinvestment risk is one of the major risks of the bond (together with interest rate risk, slightly different idea, basically if you are long the bond, you face the risk of rates rising sharply).
Fabozzi Chapter 19 talks about classical immunization is creating a bond portfolio to have a fixed return for a specific time horizon, no matter what happens to interest rates (i.e. you're hedging out the interest rate risk and reinvestment risk).
Duration matching means finding a bond of same duration as your portfolio to zero out the interest rate risk. If you have a 5 year liability and hedge with a 4 year liability you are exposed to reinvestment risk.
Active strategies are those that require rebalancing. Why so? Because the duration of the portfolio keeps changing with rates. It is not a linear function of time. The portfolio and the hedge (if we divide it into two parts) get out of step in terms of duration - the durations no longer match. How often should you rebalance is an open question.
"Classical" techniques of immunization assume parallel shifts in the yield curve. Vasicek and Fong (Journal of Finance article, 1984) established a measure for immunization risk versus arbitrary rate changes.
minimising immunization risk == minimizing reinvestment risk
Subscribe to:
Comments (Atom)