Risk Immunization

Immunization, also known as multi-period immunization, is a risk-mitigation strategy that matches the duration of assets and liabilities, minimizing the impact of interest rates on net worth over time. 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.

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

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.

In finance, interest rate immunisation, 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, immunisation 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.

Interest rate immunisation 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.

Other types of financial risks, such as foreign exchange risk or stock market risk, can be immunised using similar strategies. If the immunisation is incomplete, these strategies are usually called hedging. If the immunisation is complete, these strategies are usually called arbitrage.

Cash flow matching

Conceptually, the easiest form of immunisation 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.

Difficulties

Immunisation, 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 immunise it again. Such a process of continuous restructuring of portfolios makes immunisation 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 immunise 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.