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The basics of bond immunization

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misae
29 diapositives · 690 Views · Sep 09, 2014

The basics of bond immunization. Objective. Explain the concept of immunization and understand how it relates to bond portfolio management. Outline. Definition Exemplification Discussion of immunization. Immunization.

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The basics of bond immunization
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  1. The basics of bond immunization

  2. Objective Explain the concept of immunization and understand how it relates to bond portfolio management

  3. Outline • Definition • Exemplification • Discussion of immunization

  4. Immunization Technique that allows a bond investor to meet a future promised payment with a minimal risk

  5. Exemplification A manager has to pay $ 1,000,000 in two years. There are currently two bonds available for investment.

  6. Exemplification A manager has to pay $ 1,000,000 in two years. There are currently two bonds available for investment.

  7. Exemplification A manager has to pay $ 1,000,000 in two years. There are currently two bonds available for investment.

  8. Exemplification A manager has to pay $ 1,000,000 in two years. There are currently two bonds available for investment.

  9. Exemplification A manager has to pay $ 1,000,000 in two years. There are currently two bonds available for investment.

  10. Exemplification A manager has to pay $ 1,000,000 in two years. There are currently two bonds available for investment.

  11. Exemplification (cont’d) Since the discount rate is 10%, the present value of $ 1,000,000 is $826,446.3. The manager has to invest $ 826,446.3 at 10% in order to produce $ 1,000,000 two years from now.

  12. Alternatives: Strategy I Buy $ 826,446.3 worth of bonds A. Next year, roll-over the proceeds into a new one-year bond issue. Disadvantage Interest rates could decline one year from now A one percentage point decrease in interest rates in one year results in only [850 x $ 1,070 x (1.09)] = $991,335

  13. Alternatives: Strategy II Buy $ 826,446.3 worth of bonds B Reinvest the coupon and sell the bonds in two years Disadvantage Interest rates could increase at the time the manager has to liquidate the position. A one percentage point increase in interest rates just days before our manager liquidates the position will result in [ 870 x ($ 88 + $ 80 +$ 972.97)] = $ 992, 646.5

  14. Alternatives: Strategy III Construct a portfolio consisting of both bonds that has a duration of exactly 2 years(Immunization). Put 43.82% in A (372 bonds), and 56.18% (489 bonds) in B

  15. Immunized portfolio

  16. Immunized portfolio

  17. Immunized portfolio

  18. Immunized portfolio

  19. Immunized portfolio

  20. Immunized portfolio

  21. Immunized portfolio

  22. Immunized portfolio

  23. Immunized portfolio

  24. Immunized portfolio

  25. Immunized portfolio

  26. Immunized portfolio

  27. Comments When interest rates fall to 9%:  • the price of bond B rises • the FV of reinvested proceeds falls. When interests rates rise to 11%: • the price of bond B falls • the FV of reinvested proceeds rises

  28. The terminal value of the portfolio is not exactly $1,000,0000. Why? A. Yield changes trigger changes in portfolio duration. When duration changes the portfolio ceases to be perfectly immunized, and needs REBALANCING. B. Rounding up errors.

  29. Problems with immunization It assumes that all shifts in the yield curve all parallel The portfolio is in need of permanent rebalancing There are many combinations of bonds that work out to the desired average duration, hence, it is difficult to choose the best combination