what is meant by the Schweser notes when it says before the surplus turns negative, the portfolio must be immunized. How exactly will the portfolio be immunized so that active management can occur?
I think you are talking about contingent immunization right?
Say you are a bank and you have a $1000 CD paying interest of 4% for a client that is due in one year… This is your liability with required rate of return of 4%. You have to immunize this liability and match your investment inflow in one year to pay off that liability with the 4% interest. Now assume the YTM or market rate at issuance was 5%. since market rate (immunization rate) is higher than required rate of ruturn of 4%, then you are in the safe side and you can invest your portfolio in riskier bonds, for example invest in higher duration than the liability, which is considered an active management.
In other word, all what you need to do is compute your FV of liability with interest using 4% required rate and discount it back using the market rate (immunization rate of 5%). AFter that compare the result with the investment value you have in hand. if ithe PV of the liability is less than the portfolio value today then you can go ahead and actively manage the bond portfolio, if on the other hand the PV of the liability is equal to the portfolio value then you must meet the duration of the liability and you should halt or stop actively managing the portfolio.
Hope it make sense.
So, if the portfolio return meets the safety net return, the immunization mode is triggered. But, in the immunization mode, wh
But, what if the immunization return is less than the safety net return? Is immunization still possible or does the client now expect a loss?
If the immunization rate less than required rate, then no active management and more money should be invested to meet the liability.
Ah ok thanks