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Bond immunization


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Definition,process,features,limitations and examples of bond immunisation

Published in: Economy & Finance
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Bond immunization

  2. 2. A Bond is a debt instrument issued by governments, corporations and other entities in order to finance projects or activities. In essence, a bond is a loan that investors make to the bonds issuer.
  3. 3. Immunization is a set of rules that is being used for the purpose of minimizing the impact of a change in interest rate of a financial wealth. 3
  4. 4. Bond immunization is an investment strategy used to minimize the interest rate of bond investments by adjusting the portfolio duration to match the investors investment time horizon.
  5. 5. Immunization is a technique that makes the bond portfolio holder to be relatively stream of cash flows. The bond interest rate risk from the changes in the market interest rate. The market rate effect the coupon rate and the price of the bond . Immunization locks in a fixed rate of return during the amount of time an investor plans to keep the bond without cashing it in.
  6. 6. In general, the longer the term to maturity, the greater the sensitivity to interest rate changes. Example: Suppose the zero coupon yield curve is flat at 12%. Bond A pays $1762.34 in five years. Bond B pays $3105.85 in ten years, and both are currently priced at $1000.
  7. 7. • Bond A: P = $1000 = $1762.34/(1.12)5 • Bond B: P = $1000 = $3105.84/(1.12)10 Now suppose the interest rate increases by 1%. • Bond A: P = $1762.34/(1.13)5 = $956.53 • Bond B: P = $3105.84/(1.13)10 = $914.94  The longer maturity bond has the greater drop in price because the payment is discounted a greater number of times.
  8. 8. A portfolio is Immunized when its duration equals the investors time horizon. Maintaining an Immunized portfolio means rebalancing the portfolios average duration every time interest rates change, so that the average duration continuous to equal the investors time horizon.
  9. 9. • Default and call risk ignored • Multiple nonparallel shifts in a nonhorizontal yield curve • Costly rebalancing ignored • Choosing from a wide range of candidate bond portfolios is not very easy 9
  10. 10.  Here coupon rate risk and the price risk can be made to offset each other.  Whenever there is an increase in the market interest rate ,the prices of the bonds fall. At the same time the newly issued bonds offer higher interest rate.  The coupon can be re-invested issued bonds offer higher int rate & losses that occur due to the fall in the price of bond can be offset &the portfolio is said to be immunized.
  11. 11. Example : If an investor has invested equal amount of money in 3 bonds namely A,B&C with duration of 2,3,4 years respectively , than the bond portfolio duration is D=1/3*2+1/3*4+1/3*3 = 0.66*1*1.33 = 2.77 or 3 years
  12. 12. Every time market interest rates change the duration of every bond changes. During tends to diminish more slowly than calendar time for coupon-paying bonds when interest rates do not change.