Contingent Immunization Question

A manager of a bond fund wishes to ensure funding of a predetermined liability. Contingent immunization is possible when the prevailing available immunized rate of return is:

A)

greater than the required rate to ensure the funding, and it works best if interest rates stay the same or increase.

B)

greater than the required rate to ensure the funding, and it works best if interest rates stay the same or decline.

C)

lower than the required rate to ensure the funding, and it works best if interest rates stay the same or decline.

Answer is B, “Contingent immunization is only possible if the prevailing available immunized rate of return is greater than the required rate to ensure the funding. It works best if rates stay the same or decrease because the need to actually fully immunize never occurs”.

Is anyone able to explain why it works better if rates stay the same or decline? I basically just guessed between A & B here.

interest rates decline - your bond asset portfolio performs better. Your liability is fixed … does not change with interest rates.

thanks lol, I suck sometimes. I was thinking in the frame of a defined benefit for some reason where assets and liabilities would be dependent on rates.

Just got lost in this question. Why is the liability fixed? Shouldn’t they move together with the interest rate?

Thanks!

The present value of the liability varies with interest rates, but the value at the time it’s due is fixed.

If you match the (effective) duration of the bonds to the (Macaulay) duration of the liability, then the maturity of the bonds will be longer than the maturity of the liability, so you have to be concerned about the value of the bonds. It’ll be higher when interest rates decrease than when interest rates increase.

Got it! they are talking about the terminal value of the liability.

Thanks for the help, S2000!!

My pleasure, as always.