Reading 21, practice problem 10 says we must consider credit risk when considering immunization of a single liability. I have also seen that immunization assumes bonds will not default.
Which is correct?
I would say both at the same time? Normally, immunization assumes that bonds will not default. However, does default-free bonds really exist? I would say, no. Hence, practically we have to consider credit risk.
Where do you see immunization assumes bonds will not default?
I saw this in Schweser text
Still not clear on why credit risk is a part of immunization risk where another place indicates it is not. Do we assume there is credit risk in immunization for the exam or not?
Thank you!
Your immunization is chock full of s…t if significant part of your bond portfolio bears high credit risk. If credit risk increases in portfolio this require some action (i.e. rebalancing or hedge or both). You may recall that regulators within some sectors require only investment graded bonds and require accounting provisions for disputed Asset items.
This totally makes sense!
But do you know why they assume there is NO default risk when immunizing a portfolio as well? This just sounds contradict to each other.
“Credit rating. In immunizing a portfolio, it is implicitly assumed that none of the bonds will defult.”
It is assumed by establishing portfolio by investment graded bonds only. As time passages, if the probability of default for certain bond arise for some reason, they should immediately rebalance the bond portfolio. The good example was during global financial crisis. It was very funny situation until the FED started with their QEs, Twist and other programs.
Got it! Thanks for your help, Flashback!
I thought immunization risk is just reinvestment risk…