Question

Discuss the pros and cons of using duration matching immunization.

Answer 1

In finance, interest rate immunization, as developed by Frank Redington is a strategy that ensures that a change in interest rates will not affect the value of a portfolio.

A more practical alternative immunization method is duration matching. Here, the duration of the assets is matched with the duration of the liabilities. To make the match actually profitable under changing interest rates, the assets and liabilities are arranged so that the total convexity of the assets exceed the convexity of the liabilities. In other words, one can match the first derivatives (with respect to interest rate) of the price functions of the assets and liabilities and make sure that the second derivative of the asset price function is set to be greater than or equal to the second derivative of the liability price function.

Pros -

Large firms and institutions have the ability protect their portfolios from exposure to interest rate fluctuations by using what is known as an immunization strategy. By using a perfect immunization strategy, firms can nearly guarantee that movements in interest rates will have virtually no impact on the value of their portfolios.

Immunization can be accomplished by cash flow matching, duration matching, convexity matching, and trading forwards, futures and options on bonds. Similar strategies can be used to immunize other financial risks such as exchange rate risk.

Often investors and portfolio managers use hedging techniques to reduce specific risks. Hedging strategies are usually imperfect, but if a perfect hedging strategy is in place, it is technically an immunization strategy

It is possible to make a profit using duration match. All that needs to be done is to construct a bond portfolio in a way that the portfolio's convexity is higher than the convexity of the liabilities.

Cons -

Immunization, if possible and complete, can protect against term mismatch but not against other kinds of financial risk such as default by the borrower (i.e., the issuer of a bond). It might also be difficult to find assets with suitable cashflow structures that are necessary to ensure a particular level of overall volatility of assets to have a proper match with that of liabilities.

Once there is a change in interest rate, the entire portfolio has to be restructured to immunize it again. Such a process of continuous restructuring of portfolios makes immunization a costly and tedious task.

Users of this technique include banks, insurance companies, pension funds and bond brokers; individual investors infrequently have the resources to properly immunize their portfolios.

The disadvantage associated with duration matching is that it assumes the durations of assets and liabilities remain unchanged, which is rarely the case.