Reading 23 (CFAI Text Vol 4), at the bottom of P.28
… to immunize …, a manager must invest in a bond or a bond portfolio whose (1) duration is equal to the _ investment horizon _ and (2) initial present value of all cash flows equals the present value of future liability.
What does it mean by the “_ investment horizon _” ? Is it the duration of the future liability (liabilities) ? Can anyone advise ?
It is when the liabilities need to be paid out… after you perform the immunization.
so read it in terms of a zero coupon bond that is a bullet bond with payments around the time period when liabilities are due - will have NO REINVESTMENT risk - and therefore is the best immunization technique for a single period immunization.
cpk 123,
Sorry, your above explanation is not clear enough to me. Do you mean the investment horizon is the duration of the liability (or liabilities) as mentioned by me ?
At the bottom of P.29, under 4.1.1.4 Time Horizon, the statement : . . ? ? The _ immunized time horizon _ is equal to the portfolio duration.
Is the immunized time horizon herehhhhhhhhhhhhh hsame as the investment horizon at the bottom of P.28 ? ? ?
Investment Horizon is WHEN THE LIABILITIES ARE DUE. Say you need to make pension payments from your portfolio in 5 years - that is your Investment horizon. What you are investing for … when they are necessary to be paid out … that is exactly what I said above.
Immunized Horizon - is the same concept. You are a pension plan manager - you have to payout after 20 years to the employees on your plan. 20 Years = Investment Horizon.
You expect the interest rates to change big time - so you decide to now break up your horizon into a 5 year initial period during which you want to immunize your portfolio against interest rate risk. This 5 years = Immunized Time Horizon.
For each of the above cases - a requirement of the immunization technique is that your Portfolio Duration = Time Horizon.
In the middle of P.41, it is stated that the first condition to assure multiple liability immunization is :
The (composite) duration of the portfolio must equal the (composite) duration of the liability.
Therefore, my conclusion is : Duration of the asset (a bond or a bond portfolio) = _ Investment horizon = Immunized time horizon _ = Macaulay Duration (see foot note 27).
Macaulay Duration is in unit of “year” and Modified or Effective Duration (rather than Macaulay Duration) shall be used to measure the change in price (value) of the asset when I/R changes and to calculate the dollar duration.
I am very much confused since there are many discrepancies in these statements. Any comment ?
Anyone can help ?