CFA Reading 28, Q 10

The answer to this question states that to fully immunize a single liability using a portfolio of bonds (and remove all risk), it is necessary to: 1) set the market value of the assets equal to the present value of the liability; 2) set the duration of the portfolio equal to the duration of the liability; and 3) factor in credit risk. But isn’t the credit risk already accounted for in the market value of the assets? I feel like this question is unfairly tricky…

No. If mkt value changes due to higher credit risk, immunization goes out of the window. Immunization assumes that credit events don’t occur and prices reflect changes in interest rates only. It is tricky. due to changes in interest rates only. It is tricky.

Investors do not always get compensated for credit risk, liquidity risk, inflation risk, taxes etc as determined by the market value of the asset. Therefore one has to consider credit risk separately.

Maybe the risk in a downgrade happening , i.e. the credit worsening. That would not be built into the price. If the rating is A- , then the security may be ok to invest for a particular investor. If the rating is subsequently expected ( by the investor, not by the market) to go to BBB , then it would be appropriate to discount the price

Immunization of a single-liability only immunizes against one time parallel change in interest rates, so against interest rate risk. It doesn’t immunize the portfolio against any other type of risk.