“Immunization is the process by which an investor can protect their portfolio against interest rate risk by holding assets and liabilities of equal durations.” how does holding assets and liabilities of equal durations protect you againsty risk? i thought it would be the other way around and if you have assets and liabilities with different durations, that will be like diversifying. any ideas? thx
try to understand what duration is.
You want your liabilities to change by approximately the same amount of your assets if there are changes in interest rates. If you had different durations then your assets and liabilities would change by different amounts if there were changes in interest rates.
To increase immunity, take airborne
It’s more like hedging than diversifying. A change in interest rates makes the assets go up or down in value by some amount, but if the liabilities go up or down by the same amount, you will stop caring about what happens to interest rates, because, other things equal,your assets are still enough to cover your liabilities. You’re still exposed to other risks though, and if the interest rates move by a lot, you may need to match convexity too, which sounds harder.
well put, chadwick. Immunization is especially important to an insurance company. Example: you receive an actuary report that provides statistical evidence of claim duration – if you ladder your bond portfolio to a similar duration, your bonds are maturing at the same time your liabilities are due. Therefore, you’re immune to interest rate risk and, if you bought zeros, reinvestment rate risk.