Duration and Portfolio

Immunization
 Bond Immunization
• Bond immunization
– An investment strategy that tries to protect the
expected yield from a Bond or portfolio of
Bonds by acquiring those Bonds whose
duration equals the length of the investor’s
planned holding period.
 Bond Immunization
• If the average duration of a portfolio equals
the investor’s desired holding period, the
effect is to hold the investor’s total return
constant regardless of whether interest rates
rise or fall.`
 Example
• Assume we are interested in a Rs. 1,000 par
value bond that will mature in two years.
• The bond has a coupon rate of 8 percent and
pays Rs. 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
• The buyer knows he will receive Rs. 1000
at maturity, but in the meantime he faces
the uncertainty of having to reinvest the
annual Rs. 80 in interest earnings at 6%,
8%, or 10%.
 Example: Case 1
• Let interest rates fall to 6%.
– The bond will earn Rs.80 in interest payments
for year one, Rs. $80 for year two, and Rs. 4.80
(Rs.80 x 0.06) when the Rs.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 = Rs.1,164.80
 Example: Case 2
• Let interest rates rise to 10%.
– The bond will earn Rs.80 in interest payments
for year one, Rs.80 for year two, and Rs.8.00
(Rs.80 x 0.10) when the Rs.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 = Rs.1,168.00
 Immunization and Duration
• The investor’s earnings could drop as low as
Rs1,164.80 or rise as high as Rs.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 Rs80 in interest payments
for year one, Rs80 for year two, and Rs 4.80
(Rs80 x 0.06) when the Rs 80 interest income
received the first year is reinvested at 6%
during year 2.
– But, the bond’s market price will rise to
Rs1,001.60 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 = Rs. 1,166.40
 Example: Case 2
• Let interest rates rise to 10%.
– The bond will earn Rs80 in interest payments
for year one, Rs 80 for year two, and Rs8.00
(Rs80 x 0.10) when the Rs80 interest income
received the first year is reinvested at 10%
during year 2.
– But, the bond’s market price will fall to
Rs.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 = Rs 1,166.40
 Conclusion
• 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.
 Conclusion
• Immunization using duration seems to work
reasonably and investors can achieve
reasonably effective immunization by
approximately matching the duration of their
portfolios with their planned holding periods.
 Limitation of Duration
• In reality it can be difficult to find a
portfolio of securities whose average
portfolio duration exactly matches the
investor’s planned holding period.
– As the investor grows older, his planned
holding period grows shorter, as does the
average duration of his portfolio, but they may
not decline at the same rate.
• Portfolio requires constant adjustments.
 Limitations of Duration
• Many bonds are callable so bondholders
may find themselves with a sudden and
unexpected change in their portfolio’s
average duration.
• The future path of interest rates cannot be
perfectly forecast; therefore, immunization
with duration cannot be perfect without the
use of complicated models.