Topics

 Strategies for Interest Rate Risk Immunization

 Matching cash flows: Least cost portfolio

 Matching Duration

Interest rate immunization is a strategy to match assets and liabilities so that the present value of net worth is not

sensitive to changes in interest rates.

Least Cost Portfolio using Linear Programming

Objective:

 On each date the cash flow from the asset portfolio should match the liability

 Choose the lowest cost asset portfolio that matches liabilities as above

Problem: Assume that you have forecast the following stream of liabilities:

Projected Liabilities
Year 1 2 3
Amount 100,000 300,000 500,000

You can invest in the following bonds (assume that the bonds pay coupon annually)

Bond No. Maturity Coupon Price Number of Bonds

(%) (Pi) to purchase
1 1 5.5 99.25 n1
2 2 8.5 103.75 n2
3 2 6.75 99.75 n3
4 3 9 106.50 n4
5 3 0 82.00 n5
How will you construct a portfolio with these bonds so that you are assured all the liabilities will be met and the portfolio has the

lowest cost?

The problem can be set up as a linear programming problem.

Bond No. Number of Bonds Cash Flow

1 n1 105.5 x n1 0 0
2 n2 8.5 x n2 108.5 x n2 0
3 n3 6.75 x n3 106.75 x n3 0
4 n4 9 x n4 9 x n4 109 x n4
5 n5 0 0 100 x n5
Total
  
5 5 5
i 1
ni Ci ,1 i 1
ni Ci , 2 i 1
ni Ci , 3
 5
Minimize the cost of portfolio  min
ni n P i i
i 1

Such that the cash flow from the bond in each period is greater than or equal to the liabilities; i.e.

n C
i 1
i i ,1  100000

n C
i 1
i i,2  30000

n C
i 1
i i ,3  50000
The worksheet formulation of this problem and the solution are given below:

Bond No. n1 n2 n3 n4 n5 Cost

Solution 768. 12. 2,799. 0. 5,000. 766,669
00 00 00 00 00 .25

Price 99. 103. 99. 106. 82.

25 75 75 50 00

Year C/F n1 C/F n2 C/F n3 C/F n4 C/F n5 Total C/F Required C/F
Constraint 105. 8. 6. 9. 100,019 100,000.
No. 1 50 50 75 00 - .25 00
108. 106. 9. 300,095 300,000.
2 - 50 75 00 - .25 00
109. 100. 500,000 500,000.
3 - - - 00 00 .00 00

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 Immunization by Matching Duration and Convexity

 The strategy of immunizing by matching duration and convexities of assets and liabilities attempts to match the present values of

assets and liabilities at all levels of interest rates. This will ensure that the assets will always be sufficient to meet liabilities

regardless of changes in interest rates

 To implement this, match present values of assets and liabilities and also match their dollar durations and also (as we will later

see) match dollar convexities.

 The cash flow matching approach matches each individual cash flow of the liability with equal cash flows from assets. The

duration matching approach to immunization matches the present values of cash flows from assets and liabilities.

 Under the duration matching approach, the cash flows (such as coupons) from the asset portfolio need not exactly match the cash

flows to meet the liability stream. But the idea is that if the cash flows are not exactly matched some of the assets can be sold to

raise cash and meet liabilities.

Problem: You have a perpetual liability of $1,000,000 per year. The yield curve is flat at 10%. You plan to immunize your net

worth using two zero-coupon securities with maturities of 5 years and 20 years.

1. How much will you invest in each of these securities?

2. Will you be immunized with the position identified in part (1) if the yield changes to 11%? Why or why not?

3. Will you be immunized with the position identified in part (1) one year from now if the yield remains at 10%? Why or why

not?
Answer:

1
At y=10%, Present value of liability =  $10m . Therefore, the present value of assets should equal $10m to meet liabilities.
.1

To start with, consider the following three alternative investments: (i) x5=10m, X20=0; (ii) x5=0, X20=10m; and (iii) (i) x5=6m, X20=4m.

What will be the asset and liability values if interest rate changes today?

x5 Investment in 5-year Zero

x20 Investment in 20-year Zero
Price of $100 face value 5-yr Zero at y=10% 62.09
Price of $100 face value 20-yr Zero at y=10% 14.86
Yield Present Value Portfolio
of Liability
(1) (2)=$1m/(1) x5=10,x20=0 x5=0,x20=10 x5=6,x20=4
9.5 10.53 10.23 10.95 10.52
10 10.00 10.00 10.00 10.00
10.5 9.52 9.78 9.13 9.52
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 Under alternative (i) at y=9.5%, Va < Vl .

 Under alternative (ii) at y=10.5%, Va < Vl .

 Under alternative (iii) Va = Vl both if interest rate rises or if it falls. How did we reach this solution?
Bond/L Mac. Duration Dollar Duration
y = .1 y = .11 y = .1 y = .1 y = .11 y = .1
1 year later 1 year later
Perpetuity 11 10.09 11 -100 -82.63 -100
5-year zero 5 5 4 -4.54x5 -4.50x5 -3.64 x4
20-year zero 20 20 19 -18.18x20 -18.02x20 -17.27x19
1.

 Set Value of assets to equal value of liabilities:

x5 + x20 = 1/y = 10

 Set $ Durations of assets and liabilities to be equal.

-4.54x5 -18.18 x20 = -100

Solve to get x5 = 6m and x20 = 4m

3. Let y=.11

 Set Value of assets to equal value of liabilities:

x5 + x20 = 1/.11 = 9.09

 Set $ Durations of assets and liabilities to be equal.

-4.50x5 -18.02 x20 = -82.63

Solve to get x5 = 6m and x20 = 3.09m

3. After the passage of one year, let y=.1.

 The present value of liabilities is $11m - $1m of liability is now due and $10m is the present value of future liabilities.

 The original five-year zero will now have four years to maturity. The initial investment of $6m in original 5-year zero

would have appreciated to $6.6m (why?).

 The original 20-year zero will now have 19 years to maturity. The initial investment of $4m in original 19-year zero would

have appreciated to $4.4m (why?).

 The total asset value now is $11m. Sell $1m of assets to meet liabilities that fall due and invest the balance in the 4-year

zero and the 19-year zero.

 Set Value of assets to equal value of liabilities:

X4 + x19 = 1/.1 =10

 Set $ Durations of assets and liabilities to be equal.

-3.64x4 -17.27 x19 = -100

Solve to get x4 = 5.3m and x19 = 4.7m

 Cash Flow Matching Versus Matching Duration

The cash flow matching strategy has the following advantages:

 The liabilities will always be met with the cash flows from the assets regardless of any future change in interest rates

 This strategy will enable immunization at the lowest cost

 One the assets and liabilities are matched on cash flows no portfolio revision is necessary

However,

 Cash flow matching strategy cannot be applied if the future cash flows are not known with certainty, e.g. if there are options or

futures contracts in the asset portfolio, future cash flows are uncertain and hence cannot be specified in the constratins

 In such situations match present values of future cash flows from assets to present values of the liability stream - Match durations

 A position that is immunized by duration matching at one point in time need not stay immunized with changes in interest rates or

with the passage of time.

 Financial institutions, therefore, set up systems to constantly monitor their interest rate risk exposure and immunize their positions

either by changing their asset mix (which may occur in the normal course of trading) or by taking offsetting positions in the futures

market.