“”reinvestment risk determines immunization risk”. Why? what happen to the interest risk and fluctuation in bond price? does interest rate risk only matter if you are retiring the bond before maturity and it doesnt matter if you are retiring the bond on maturity since it will be par price?
more in general, can someone just put it simple and easy, why are we matching all the duration? just so that we can most perfectly ensure when the time come we can pay for our bond in the end regardless of interest and market change?
you are not buying the bond to pay off the bond. You are buying the bond on your portfolio to help pay off some other liability that will come due when the bond matures. at that time you will sell the bond and pay off the liability. hence the need to match the duration (OF THE LIABILITY with the ASSET (your bond purchase)).
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now think about the other question - if you are reinvesting coupons that the bond pays - they add on to the asset’s payoffs - hence contribute towards the amount that you will be accumulating towards the liability. The bigger that payoff is (higher your reinvestment return) your immunization return is better. Hence reinvestment risk (bigger risk here) will contribute more towards your immunization risk.
Immunization is ensuring that the bond payoffs are what you need from a liability standpoint. (match the changes in interest rate and hence market value of your bond asset against what you want for meeting your liability (also called defeasing the liability)).
amazing explanation, makes total sense, now expanding that a little, why does the range of durations of assets have to be greater than the range of duration of liabilities? can you explain that from the interest rate increase decrease point of view, in way that so if intereat rate drop, you have risk that bond will retire earlier and doesnt meet the duration of your liability? and in that way if you have a bond that has even longer liability you can potentially avoid this?
So interest risk is if my bond is retiring earlier? and if we are waiting till maturity for sure this wont be a problem…?
interest rate increase - causes bond to be worth less at its horizon. So you might end up with a situation that the bond will not be worth as much as required to defease the liability. To allow for that - you need the bond to be NOT EXACTLY HORIZON matched - but say 1 to 2 years beyond when the liability is due. that would permit you to maybe rebalance, buy some more assets etc. make an adjustment to meet your liability when it becomes due.
even if interest rate decreases - you are still not horizon matched in terms of paying off the liability. no one wants to pay off a “fixed” debt (your liability) earlier. Even if you did, you do not gain any brownie points.
i think here is where i get confused, you mentioned
you need the bond to be NOT EXACTLY HORIZON matched - but say 1 to 2 years beyond when the liability is due. that would permit you to maybe rebalance, buy some more assets etc. make an adjustment to meet your liability when it becomes due.
so if my duration is one or two years longer, that means my bond is slightly more expensive, has a cushion in comparison so i can afford the rate increase? how is this relate to what you mentioned about rebalancing?