Immunization and Hedging in Fixed Income…I know they are different. Can you explain the difference between the two? Anything common between the two?
What I see is that in immunization you are trying to match two things: assets and liabilities. See that assets can cover liabilities such that interest rate movements do not affect the portfolio. In hedging I feel that you are covering or protecting an asset. See that interest rate movements do not affect a particular asset. Also if immunization is not complete, then it could be termed as hedging. And if it is complete, then could be termed as arbitrage. Would love to hear other views as well.
Hedging is more of a strategy designed to reduce investment risk or to help lock in profits. Overall purpose being to reduce volatility of a portfolio by reducing the risk of loss. Derivatives, calls, puts, forwards and futures can be used to do this. Immunization is a strategy centered around the matching up or assets to future liabilities (mostly used with pension funds and annuity providers). Immunization involves investing in securities with a certain expected return so that the investor can pay for the future liabilities. Portfolio Immunization investors usually invest in low risk, investment grade securities. http://financial-dictionary.thefreedictionary.com/Immunization
If a fixed-income portfolio is immunized, it gives the assurance to the investor that the portfolio will earn a minimum rate of return called the safety net. The difference between the current rate of return and the safety net is called the cushion.
Thank you all. I have four statements, but I’m not sure they are correct or not. Can you please confirm if they are right or wrong? 1) In immunization, the benchmark is one or more liabilities. In other words, no interest rate hedging in immunization. (I refer to the Exhitbit 1 on Page 7, Curriculum Volume 4). 2) The purpose of the immunization strategy is to immunize the liabilities against interest rate changes. 3) The liabilitites are not part of the immunized portfolio. The immunized portfolio includes the fixed income assets only. 4) The derivatives are not needed in an immunized portfolio.
Based on Wikipedia: “In finance, interest rate immunization is a strategy that ensures that a change in interest rates will not affect the value of a portfolio. Similarly, immunization can be used to ensure that the value of a pension fund’s or a firm’s assets will increase or decrease in exactly the opposite amount of their liabilities, thus leaving the value of the pension fund’s surplus or firm’s equity unchanged, regardless of changes in the interest rate. Interest rate immunization can be accomplished by several methods, including cash flow matching, duration matching, and volatility and convexity matching. It can also be accomplished by trading in bond forwards, futures, or options. Other types of financial risks, such as foreign exchange risk or stock market risk, can be immunized using similar strategies. If the immunization is incomplete, these strategies are usually called hedging. If the immunization is complete, these strategies are usually called arbitrage.” Either way, I doubt that it will be important to clearly distinguish between immunization and hedging. These terms are loosely defined anyway.
Wow, it looks a topics beyond 6/4. I’ll move on. Thanks, again.
In the Linking Pension Assets and Liabilities chapter, we learnt that the best pension portfolio will mimic the liability exposures of the pension plan. so, we match real rate bonds to benefits / future wage accruals linked to CPI and we use nominal bonds to finance benefits w. fixed cash flows. but then, in the last page, we talk about using derivatives to hedge interest rate risk why do we have any interest rate risk remaining if we’ve mimicked our liability exposures?