Hi - can anyone explain the logic behind contingent immunization (Schweser example is in book 3, page 33-35).
Seems like you calculate what you want the future value of the portfolio to be, then discount back at the immunized rate. Then, you put in more than that, and that is your ‘dollar saftey margin.’ Here is where I am unclear - do you actively manage the whole thing, then if the value of the portfolio falls to the discounted value above, you immunize? In the example, rates jump to 12% immeadietely, would you have needed to immunize as the rates were rising?
Guess I am unclear on the timing and logic behind the last step - moving from active mgmt to immunized.
For the Liability - you know the horizon date (when it would be due) and what the amount will be… -> this is based on the Target rate. --> Terminal Value.
When you start - if the value that your Assets will grow to at the horizon > Value on your liabilities required at the horizon - you have some spare room (Cushion) which can be “Actively invested” and earn more returns.
If the rates happen to change immediately … recalculate what the “assets would have become”.
Calculate what the Liabilities would be when the rate jumped up. -> Terminal Value discounted back at the new rate.
If still the Assets > Liabilities … you still have room - so you can continue with your Active Strategy.
But if Assets < Liabilities - you can no longer proceed with Active mode - and need to “immunize” which means move to Passive strategy.
For all this however to work - a. your Portfolio Asset Duration should match the Liability Duration. [It should not matter which definition of Duration is used … to the point of inflaming this forum … I am writing this … because next someone will ask “what is the definition of the duration …” (been there, done that).].
In real world, it’s a very rare event that a rate jumps more than 1% immediately…The rate change will take time. Let’s say the rate rises gradually and the dollar saftey margin shrinks accordingly. The manager usually has enough time to respond(switch to immunization mode) if the dollar saftey margin approaches to zero.
In a worst case scenario, the rate jumps so high and so quickly that the dollar saftey margin is deep into negative. Switching to immunization still applies.
Thanks guys. The Schweser example of rates moving immediately by a large margin threw me off.
Seems like the general concept is to continually monitor how much cash is needed to immunize the liability, then look at the market value of your portfolio (which could have a different duration from your liability), and when dollar safety margin declines, switch to an immunized portfolio.
