How to achieve immunisation? Mock Exam Item Set Questions. Chesepeake, Q3

CFA Level III
#1

I read from the answer key for the Mock Exam Item Set Questions. Chesepeake, Q3

"To immunize a portfolio’s target value or target yield against a change in the market yield, a manager must invest in a bond or a bond portfolio whose 1)duration is equal to the investment horizon and 2) initial present value of all cash flows equals the present value of the future liability.

Why would that make a perfect immunisation? Any other ways to achieve it?

Additionally, if he matches the bond portfolio with the same yield to maturity equal to the target yield and a maturity equal to the investment horizon, and wait it out, why wouldn’t that make a perfect immunisation assuming there was no bond being called, and despite fluctuation, the terminal value would be the same (thus making it a perfect immunisation), right?

Feel free to get back to me after this weekend, I just want to know for the sake of knowledge. Thanks!!

#2

This is classical immunization. 1)duration is equal to the investment horizon and 2) initial present value of all cash flows equals the present value of the future liability. You also need to know that price risk will be eliminated by reinvestment risk and vice versa, + duration matching is important + parallel shifts.

That’s all about it for classical immunization.

#3

What do you mean by this?

#4

If interest rates increase, price will decrease but will be eliminated by increase in reinvestment income

If rates decrease, price will increase but will be offset by decrease in reinvestment income

#5

Yeah, this is what I thought :slight_smile: Thanks!

#6

just to clarify, you will need three right

1)duration is equal to the investment horizon and 2) initial present value of all cash flows equals the present value of the future liability. 3) price risk will be eliminated by reinvestment risk and vice versa

I understand price risk and reinvestment risk need to cancel each other out, just wonder if duration match or NPV match have already taken care of that or not.

Thanks!!