Immunising a single liabilities

CFA Level III Fixed Income
#1

AL Capital (ALC), a global asset management company, specializes in active bond
management for institutional clients. Andy Brown is a newly hired portfolio manager at
ALC. Brown is meeting with a prospective client, John Green, of Taboo Manufacturing
™. Green informs Brown that TM has a single $200 million liability due in seven years
with a fixed coupon of 5%. Green wants to construct a bond portfolio to immunize this
obligation.

Portfolio A: Macaulay duration : 7 years
Convexity:34
Portfolio B : Macaulay duration: 7.3 years
Convexity: 14
Why Portfolio B is not selected despite it has lower convexity. Is 0.3 years difference is material?

#2

Duration is far more important than convexity. Light years more important.

#3

You can refer to the textbook, for single liability immunization, three requirments should be met

has an initial market value that equals or exceeds the present value of the liability;

has a portfolio Macaulay duration that matches the liability’s due date;

minimizes the portfolio convexity statistic.

If the convexity of the liability is provided, the final decision could be made.

In my opinion, judging only from Macaulay Duration is a not persuasive enough.

#4

Got it. Thanks

#5

Furthermore, those requirements are listed in order of importance:

  • Value
  • Duration
  • Convexity