The simplest way to immunize would be to buy zero-coupon bond with same horizon as the liability.
But the return from this approach is normally inadequate ( zero-coupon bond could be in high demand requiring a premium, for eg).
Hence, the role of the manager, trying to add value by identifying different bonds as potential candidates for immunization to achieve the same target. Plus transaction costs will make the portfolio return less than a “paper” index requiring the manager to seek ways to compensate.
Thanks ganeshrpl. This makes it clear. I’d completely taken the possibilty of bonds to be called earlier to maturity out of the picture.
Is it normal for the bonds to exhibit this behavior when the interest rates rise? I remember reading that firms usually have restrictions on calling bonds prior to matury by borrowing capital for an interest rate that is lesser than the coupon rate. Is this a special case or this restriction holds for all bonds?
Of course, the bonds can be called off using firm’s equity capital but the reason for my above stated questions stems from my curiosity to know how easily the calling of bonds prior to maturity can happen in the market.
Thanks for your help guys. It is much appreciated.
"I guess i need to brush up on my duration understanding, but how is it that duration (as the measurement of price sensitivity to interest rates) equals or roughly equals duration (as a weighted average time of future cash flows).
I understand how time relates / effects duration but I just don’t understand how the two measurements (which measure two different things) are essentially equal. Anyone?"
I am not sure if right but here is my understanding of it:
Price sensitivity arises because change in interest rates affects PV of cash flows far in to the future more than it affects the more immediate cash flows. Hence longer maturity bonds will have greater price sensitivity and consequently higher duration.
Longer maturtiy bonds will also have higher weighted average time of future cash flows. So essentially, both concepts of duration are measuring the same thing ie how far in the future are my cash flows concentrated (which implies higher interest rate sensitivity).