What are the risks associated with a bond immunization strategy?
What will be an ideal response?
As described below, there are risks that can upset various types of bond immunization strategies.
A first risk involves uncertainty as to how the yield curve might shift. For example, if there is a change in interest rates that does not correspond to the shape-preserving shift, matching the portfolio's duration to the liability's duration will not assure immunization. The sufficient condition for the immunization of a single liability is that the duration of the portfolio be equal to the duration of the liability. However, a portfolio will be immunized against interest-rate changes only if the yield curve is flat and any changes in the yield curve are parallel changes (i.e., interest rates move either up or down by the same number of basis points for all maturities). Duration is a measure of price volatility for parallel shifts in the yield curve. If there is a change in interest rates that does not correspond to this shape-preserving shift, matching the portfolio's duration to the liability's duration will not assure immunization. That is, the target yield will no longer be the minimum total return for the portfolio.
A second risk involves the reinvestment rate. For example, consider the example in the text where the accumulated value for a barbell portfolio at the liability due date misses the target accumulated value by more than a bullet portfolio. There are two reasons for this. First, the lower reinvestment rates are experienced on the barbell portfolio for larger interim cash flows over a longer time period than on the bullet portfolio. Second, the portion of the barbell portfolio still outstanding at the end of the liability due date is much longer than the maturity of the bullet portfolio, resulting in a greater capital loss for the barbell than for the bullet. Thus the bullet portfolio has less risk exposure than the barbell portfolio to any changes in the interest-rate structure that might occur.
What should be evident from this analysis is that immunization risk is the risk of reinvestment. The portfolio that has the least reinvestment risk will have the least immunization risk. When there is a high dispersion of cash flows around the liability due date, the portfolio is exposed to high reinvestment risk. When the cash flows are concentrated around the liability due date, the portfolio is subject to low reinvestment risk.
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