Question

Discuss immunization in financial institutions

Answer 1

Immunization of Financial Institutions:

Immunization is an important strategy that banks can use to reduce risks. We try to match the duration of assets and liabilities and eliminate the issues due to the reduction in value through interest rate fluctuations. If a financial institution goes through immunization properly, its net worth will have minimal impact on fluctuations in interest rates.

Full Immunization: Investment in a security with a defined return irrespective of any changes in interest rate.

Importance of Immunization in Financial Institutions:

- Financial institutions face upcoming liabilities that are due. For example, a lump sum payment coming up in one year. The payment will need to be made and cannot be risked. Immunization helps in doing the payment.

- Interest rate fluctuations may lead to huge losses in portfolio, immunization helps in keeping portfolio stable

- It fosters public confidence. If a financial institution defaults on the liability, it is not a good signal for the shareholders and the public at large

--

Basic Ways- How do you implement?

Investment in a zero-coupon bond and matching the maturity of the bond to when the money is needed. This eliminates any risk associated with reinvestments. Commonly, duration is the parameter used for bond immunization.

There are multiple ways of carrying this out including investments in forwards, futures and options. It may also be implemented through matching convexity.

It may also be observed that a perfect hedge will act as an immunization strategy.

--

Two Real World ways of doing Immunization:

1. Cash Flow matching: Suppose the financial institution A need $500 in two years. It will buy a security that gives it the sum irrespective of the market conditions. Let’s say the institution bought a zero-coupon bond. This bond must be redeemed at $500 in two years and thus, it will remove the risk of interest rate fluctuations.

2. Duration Matching: Match a portfolios duration to investment horizon. For example, If an institute needs $500 in two years. He can purchase 10 coupon bonds with an average duration of two years. These will sum up to give a redemption value of $500

Downside:

- There is the opportunity cost if the assets increase and the liabilities do not, the portfolio might not make gains. However, for financial institutions, if there are big payments due, it is a risk that may be taken.

- It does not mitigate any other risk. For example, if the institution from which bond is taken collapses. The financial institution may be in greater trouble.

There are also many difficulties in immunization for institutions in real life:

1. Interest rate changes: If rate changes, whole portfolio needs restructuring. This might cause a significant effort for institutions,

2. Difficulty in finding assets that are appropriate to give the risk cover,

3. The approach assumes that duration of assets and liabilities will remain the same, which does not happen most of the times.