Immunization

What Is Immunization?

Also known as multi-period immunization, it is a risk-mitigation strategy that helps to match the duration of liabilities and assets, decreasing the effect of interest rates on Net worth over a period of time.

For instance, large banks have to protect their current net worth, while pension funds have the payment Obligation after a specific number of years. These financial institutions are concerned about safeguarding the portfolios’ future value and should also deal with indeterminate future interest rates.

How Does it Work?

Immunization assists massive institutions and firms in protecting their portfolios from getting exposed to the fluctuations in interest rate. With an adequate immunization strategy, companies can guarantee that the movements in interest rates will have no effect on the portfolios’ value virtually.

Furthermore, it is also regarded as the quasi-active risk mitigation strategy, considering that it carries the characteristics of both passive as well as active strategies. In simple words, pure immunization demonstrates that the Portfolio is invested for a specific return for a defined time period, irrespective of any influence from the outside world.

The opportunity cost of using this strategy is probably giving up the potential of the upside of an active strategy for the reassurance that the portfolio will acquire the anticipated return. Similar to the buy-and-hold strategy, in this one, best-suited instruments are high-grade Bonds that have remote possibilities of going Default.

Not just that, but the real immunization form would be to invest in the zero-coupon bond and match the bond’s maturity to the date when the cash flow is anticipated to be needed. This eradicates return variability, be it negative or positive, linked with the cash flow reinvestment.

Examples of Immunization

With the duration method, to immunize a specific bond portfolio, the investor has to match the duration of the portfolio to the time horizon of the investment. Suppose an investor has an Rs. 10,000 obligation in the next 5 years.

There could be a few different ways in which he could easily get the most out of duration matching. To begin with, the investor can buy a zero-coupon bond that gets matured in 5 years and is equal to Rs. 10,000.

If not, the investor can buy a variety of coupon bonds that have a duration of 5 years each and would be worth Rs. 10,000 in total.