According to financial theories, interest rate immunization is a scheme, which assures that a variation in rate of interest does not influence the portfolio value. Likewise, interest rate immunization may also be implemented to assure that the value of the assets or pension funds of a firm will go up or go down precisely in a reverse manner to the value of the liabilities. Therefore, the equity of the firm or pension fund surplus value of the firm is left unaltered irrespective of the variations in the rate of interest.
The process of interest rate immunization can be performed with the help of numerous methods that include duration matching, cash flow matching, convexity matching, as well as volatility matching. It may also be achieved in case of trades in bond options, bond futures or bond forwards.
Different forms of financial risks, for example, share market risk and foreign exchange risk may be immunized with the implementation of such plans. In case there is an incomplete immunization, these schemes are normally termed as hedging. If there is a complete immunization, these plans are generally termed as arbitrage.
In terms of conceptualization, the easiest type of immunization is cash flow matching. However, a firm, which has a number of anticipated cash flows, may discover that cash flow matching is a troublesome process and it is costly to accomplish in practical applications.
Another option of interest rate immunization, which is more pragmatic in nature is the duration matching. In this case, the first derivative of the price function of the asset regarding the rate of interest or the term period of the assets is equated with the term period of the liabilities. In order to do the matching more precise, the second derivative or convexity of the liabilities and assets may also be tallied.
In practical applications, interest rate immunization may also be performed for a portfolio consisting of only one form of asset, for example, government bonds. In this process, short and long positions are created on the yield curve. Normally, a portfolio can be immunized from the risk elements that are prevailing in a substantial extent. A major constituent analysis of variations along the yield curve of the Department of Treasury, United States Government shows that greater than 90 percent of the yield curve shifts have parallel shifts and these are succeeded by a lower percent of slope shifts, as well as a substantially lower percent of curvature shifts.
With the help of this cognition, an immunized portfolio may be constituted by forming long positions with term periods at the short end and the long end of the curve, as well as a corresponding short position with a term period in the midsection of the curve. These positions offer protection from slope changes and parallel shifts in substitution of curvature variation exposure.
Last Updated on : 1st July 2013