21 Immunization Strategies

21.1 Overview

A bond portfolio’s value in the future depends on the interest-rate structure

prevailing up to and including the date at which the portfolio is liquidated. If
a portfolio has the same payoff at some specific future date, no matter what
interest-rate structure prevails, then it is said to be immunized. This chapter
discusses immunization strategies, which are closely related to the conception
of duration discussed in Chapter 20. Immunization strategies have been dis-
cussed for many concepts of duration, but this chapter is restricted to the
simplest duration concept, that of Macaulay.

21.2 A Basic Simple Model of Immunization

Consider the following situation: A firm has a known future obligation, Q (a

good example would be an insurance firm, which knows that it has to make a
payment in the future). The discounted value of this obligation is
Q
V0 =
(1 + r ) N
where r is the appropriate discount rate.
Suppose that this future obligation is hedged by a bond held by the firm.
By this we mean that the firm currently holds a bond, whose value VB is equal
to the discounted value of the future obligation, V0. If P1, P2, … PM is the
stream of anticipated payments made by the bond, then the bond’s present
value is given by
M
Pt
VB = ∑
t = 1 (1 + r )
t

Now suppose that the underlying interest rate, r, changes to r + Δr. Using a
first-order linear approximation, we find that the new value of the future obli-
gation is given by
dV0 ⎡ − NQ ⎤
V0 + ΔV0 ≈ V0 + Δr = V0 + Δr ⎢ N +1 ⎥
dr ⎣ (1 + r ) ⎦

However, the new value of the bond is given by

540 Chapter 21

dVB N
−tPt
VB + ΔVB ≈ VB + Δr = VB + Δr ∑
t = 1 (1 + r )
t +1
dr

If these two expressions are equal, a change in r will not affect the hedging
properties of the company’s portfolio. Setting the expressions equal gives us
the condition
N
−tPt ⎡ − NQ ⎤
VB + Δr ∑ = V0 + Δr ⎢ N +1 ⎥
t = 1 (1 + r ) ⎣ (1 + r ) ⎦
t +1

Recalling that
Q
VB = V0 =
(1 + r ) N
we can simplify this expression to get

1 M tPt
∑
VB t =1 (1 + r )t
=N

The last equation is worth restating as a formal proposition: Suppose that

the term structure of interest rates is always flat (that is, the discount rate for
a cash flow occurring at all future times is the same) or that the term structure
moves up or down in parallel movements. Then a necessary and sufficient
condition that the market value of an asset be equal under all changes of the
discount rate r to the market value of a future obligation Q is that the duration
of the asset equal the duration of the obligation. Here we understand the word
“equal” to mean equal in the sense of a first-order approximation.
An obligation against which an asset of this type is held is said to be
immunized.
The above statement has two critical limitations:

• The immunization discussed applies only to first-order approximations.

When we get to a numerical example in the succeeding sections, we shall see
that there is a big difference between first-order equality and “true” equality.
In Animal Farm, George Orwell made the same observation about the barn-
yard: “All animals are equal, but some animals are more equal than others.”
• We have assumed either that the term structure is flat or that the term struc-
ture moves up or down in parallel movements. At best, this might be consid-
ered to be a poor approximation of reality (recall the term structure graphs in
541 Immunization Strategies

section 20.5). Alternative theories of the term structure lead to alternative

definitions of duration and immunization (for alternatives, see Bierwag et al.,
1981, 1983a, 1983b; Cox, Ingersoll, and Ross, 1985; Vasicek, 1977). In an
empirical investigation of these alternatives, Gultekin and Rogalski (1984)
found that the simple Macaulay duration we use in this chapter works at least
as well as any of the alternatives.

21.3 A Numerical Example

In this section we consider a basic numerical immunization example. Suppose

you are trying to immunize a year-10 obligation whose present value is $1,000
(this means that, at the current interest rate of 6%, its future value is
$1,000 · (1.06)10 = $1,790.85. You intend to immunize the obligation by pur-
chasing $1,000 worth of a bond or a combination of bonds.
You consider three bonds:

• Bond 1 has 10 years remaining until maturity, a coupon rate of 6.7%, and a
face value of $1,000.
• Bond 2 has 15 years until maturity, a coupon rate of 6.988%, and a face
value of $1,000.
• Bond 3 has 30 years until maturity, a coupon rate of 5.9%, and a face value
of $1,000.

At the existing yield to maturity of 6%, the prices of the bonds differ.
10
67 1, 000
Bond 1, for example, is worth $1, 051.52 = ∑ + ; thus, in
t (1.06 ) (1.06 )10
t

order to purchase $1,000 worth of this bond, you have to purchase

$951 = $1,000/$1,051.52 of face value of the bond.
Bond 3, however, is currently worth $986.24, so that in order to buy $1,000
of market value of this bond, you will have to buy $1,013.96 of face value of
the bond. If you intend to use this bond to finance a $1,790.85 obligation 10
years from now, here’s a schematic of the problem you face:
 542 Chapter 21

THE IMMUNIZATION PROBLEM

Illustrated here for the 30-year bond.

Year 10:
Future obligation of
$1,790.85 due.
0 30

Buy $1,014
face value
of 30-year Reinvest Sell bond for PV of
bond. coupons remaining coupons
from bond and redemption in
during year 30.
years 1-10.

When the interest rate increases:

Value of Value of bond in

reinvested year 10 decreases.
coupons
increases.
When the interest rate decreases:
Value of Value of bond in
reinvested year 10
coupons increases.
decreases.

As we will see below, the 30-year bond will exactly finance the future
obligation of $1,790.85 only for the case in which the current market interest
rate of 6% remains unchanged.
Here is a summary of price and duration information for the three bonds:

A B C D E
1 BASIC IMMUNIZATION EXAMPLE WITH 3 BONDS
2 Yield to maturity 6%
3
4 Bond 1 Bond 2 Bond 3
5 Coupon rate 6.70% 6.988% 5.90%
6 Maturity 10 15 30
7 Face value 1,000 1,000 1,000
8
9 Bond price $1,051.52 $1,095.96 $986.24 <-- =-PV($B$2,D6,D5*D7)+D7/(1+$B$2)^D6
10 Face value equal to $1,000 of market value $ 951.00 $ 912.44 $ 1,013.96 <-- =D7/D9*D7
11
12 Duration 7.6655 10.0000 14.6361 <-- =dduration(D6,D5,$B$2,1)
 543 Immunization Strategies

Note that to calculate the duration, we have used the “home-made” DDuration
function defined in Chapter 20.
If the yield to maturity doesn’t change, then you will be able to reinvest
each coupon at 6%. Thus, bond 2, for example, will give a terminal wealth at
the end of 10 years, of
9
⎡ 5 69.88 1, 000 ⎤
∑ 69 . 88 ⋅ ( 1 . 06 )t
+ ⎢∑ + 5⎥
= 921.07 + 1, 041.62 = 1, 962.69
⎣ t =1 (1.06 ) (1.06 ) ⎦
t
t =0

9
The first term in this expression, ∑ 69.88 ⋅ (1.06) , t
is the sum of the
t =0

5
1, 000 69.88
reinvested coupons. The second and third terms,
(1.06 )5
, ∑ (1.06) t
+
t =1

represent the market value of the bond in year 10, when the bond has 5 more
years until maturity. Since we will be buying only $912.44 of face value of
this bond, we have, at the end of 10 years, 0.91244*$1,962.69 = $1,790.85.
This is exactly the amount we wanted to have at this date. The results of this
calculation for all three bonds, provided there is no change in the yield to
maturity, are given in the following table:

A B C D E
14 New yield to maturity 6%
15
16 Bond 1 Bond 2 Bond 3
17 Bond price $1,000.00 $1,041.62 $988.53 <-- =-PV($B$14,D6-10,D5*D7)+D7/(1+$B$14)^(D6-10)
18 Reinvested coupons $883.11 $921.07 $777.67 =-FV($B$14,10,D5*D7)
19 Total $1,883.11 $1,962.69 $1,766.20 <-- =D17+D18
20
21 Multiply by percent of face value bought 95.10% 91.24% 101.40% <-- =D10/1000
22 Product $ 1,790.85 $ 1,790.85 $ 1,790.85 <-- =D21*D19

The upshot of this table is that purchasing $1,000 of any of the three bonds
will provide—10 years from now—funding for your future obligation of
$1,790.85, provided the market interest rate of 6% doesn’t change.
Now suppose that immediately after you purchase the bonds the yield to
maturity changes to some new value and stays there. This will obviously affect
the calculation we did above. For example, if the yield falls to 5%, the table
will now look as follows:
 544 Chapter 21

A B C D E
14 New yield to m aturity 5%
15
16 Bond 1 Bond 2 Bond 3
17 Bond price $1,000.00 $1,086.07 $1,112.16 <-- =-PV($B$14,D6-10,D5*D7)+D7/(1+$B$14)^(D6-10)
18 Reinvested coupons $842.72 $878.94 $742.10 =-FV($B$14,10,D5*D7)
19 Total $1,842.72 $1,965.01 $1,854.26 <-- =D17+D18
20
21 Multiply by percent of face value bought 95.10% 91.24% 101.40% <-- =D10/1000
22 Product $ 1,752.43 $ 1,792.97 $ 1,880.14 <-- =D21*D19

Thus, if the yield falls, bond 1 will no longer fund our obligation, whereas
bond 3 will overfund it. Bond 2’s ability to fund the obligation—not surpris-
ingly, in view of the fact that its duration is exactly 10 years—hardly changes.
We can repeat this calculation for any new yield to maturity. The results are
shown in the figure below, which was produced by running a Data|Table (see
Chapter 31):

ImmunizaƟon ProperƟes of the Three Bonds

2,900

2,700

2,500

2,300

2,100

1,900

1,700

1,500
0% 2% 4% 6% 8% 10% 12% 14% 16%

Bond 1 Bond 2 Bond 3

Clearly, if you want an immunized strategy, you should buy bond 2!

 545 Immunization Strategies

21.4 Convexity: A Continuation of Our Immunization Experiment

The duration of a portfolio is the weighted average duration of the assets in

the portfolio. This means that there is another way to get a bond investment
with a duration of 10: If we invest $665.09 in bond 1 and $344.91 in bond 3,
the resulting portfolio also has a duration of 10. These weights are calculated
as follows:

λ ∗ DurationBond 1 + (1 − λ ) ∗ DurationBond 3 = 7.6655λ + 14.6361(1 − λ ) = 10

Suppose we repeat our experiment with this portfolio of bonds. Starting in row
15 of the spreadsheet below, we repeat the experiment of the previous section
(varying the YTM), but add in the portfolio of bond 1 and bond 3. The results
below show that the future value in row 23 does not vary for the portfolio.

A B C D E F G
1 EXPERIMENTING WITH BOND PORTFOLIOS AND CONVEXITY
2 Yield to maturity (YTM) 6%
3
4 Bond 1 Bond 2 Bond 3
5 Coupon rate 6.70% 6.988% 5.90%
6 Maturity 10 15 30
7 Face value 1,000 1,000 1,000
8
9 Bond price $1,051.52 $1,095.96 $986.24 <-- =-PV($B$2,D6,D5*D7)+D7/(1+$B$2)^D6
10 Face value equal to $1,000 of market value $ 951.00 $ 912.44 $ 1,013.96 <-- =D7/D9*D7
11
12 Duration 7.6655 10.0000 14.6361 <-- =dduration(D6,D5,$B$2,1)
13
14
15 New YTM 7%
16
Bond 1 & 3
Bond 1 Bond 2 Bond 3
17 portfolio
18 Bond price $1,000.00 $999.51 $883.47
19 Reinvested coupons $925.70 $965.49 $815.17
20 Total $1,925.70 $1,965.00 $1,698.64
21
22 Multiply by percent of face value bought 95.10% 91.24% 101.40%
23 Product $ 1,831.35 $ 1,792.95 $ 1,722.34 $ 1,794.84 <-- =B26*B23+(1-B26)*D23
24
25 Portfolio of bonds 1 and 3
26 Proportion of bond 1 0.6651 <-- =(10-D12)/(B12-D12)
27 Proportion of bond 3 0.3349 <-- =1-B26
546 Chapter 21

Building a data table based on this experiment and graphing the results shows
that the portfolio’s performance is better than that of bond 2 by itself:

Performance of Bond 2 versus Bond Porƞolio

2,100

2,000

1,900

1,800

1,700

1,600

1,500
0% 2% 4% 6% 8% 10% 12% 14% 16%

Bond 2 Bond porƞolio

Convexity

Look again at the graph: Notice that, while for both bond 2 and the bond
portfolio, the terminal value is somewhat convex in the yield to maturity, the
terminal value of the portfolio is more convex than that of the single bond.
Redington (1952), one of the influential propagators of the concept of duration
and immunization, thought this convexity very desirable, and we can see why:
No matter what the change in the yield to maturity, the portfolio of bonds
provides more overfunding of the future obligation than the single bond. This
is obviously a desirable property for an immunized portfolio, and it leads us
to formulate the following rule:

In a comparison between two immunized portfolios, both of which are to fund a known
future obligation, the portfolio whose terminal value is more convex with respect to
changes in the yield to maturity is preferable.1

1. There is another interpretation of the convexity shown in this example: It shows the impossibil-
ity of parallel changes in the term structure! If such changes describe the uncertainty relating to
the term structure, a bond position can be chosen which always benefits from changes in the term
structure. This is an arbitrage, and therefore impossible. I thank Zvi Wiener for pointing this out
to me.
 547 Immunization Strategies

21.5 Building a Better Mousetrap

Despite what was said in the preceding section, there is some interest in deriv-
ing the characteristics of a bond portfolio whose terminal value is as insensitive
to changes in the yield as possible. One way of improving the performance
(when so defined) of the bond portfolio is not only to match the first deriva-
tives of the change in value (which, as we saw in section 20.3, leads to the
duration concept), but also to match the second derivatives.
A direct extension of the analysis of section 20.3 leads us to the conclusion
that matching the second derivatives requires:

1 M t (t + 1) Pt
N ( N + 1) = ∑
VB t =1 (1 + r )t

The following example illustrates the kind of improvement that can be made
in a portfolio where the second derivatives are also matched. Consider 4 bonds,
one of which, bond 2, is our old friend from the previous example, whose
duration is exactly 10. The bonds are described in the following table:

A B C D E F
1 BOND CONVEXITY
2 Yield to maturity 6%
3
4 Bond 1 Bond 2 Bond 3 Bond 4
5 Coupon rate 4.50% 6.988% 3.50% 11.00%
6 Maturity 20 15 14 10
7 Face value 1,000 1,000 1,000 1,000
8
9 Bond price $827.95 $1,095.96 $767.63 $1,368.00 <-- =-PV($B$2,E6,E5*E7)+E7/(1+$B$2)^E6
10 Face value equal to $1,000 of market value $ 1,207.80 $ 912.44 $ 1,302.72 $ 730.99 <-- =E7/E9*E7
11
12 Duration 12.8964 10.0000 10.8484 7.0539 <-- =dduration(E6,E5,$B$2,1)
13 Second derivative of duration 229.0873 136.4996 148.7023 67.5980 <-- =secondDur(E6,E5,$B$2)/bondprice(E6,E5,$B$2)
548 Chapter 21

Here secondDur(numberPayments, couponRate, YTM) is a

VBA function we have defined to calculate the second derivative of the
duration:

Function secondDur(numberPayments, couponRate,

YTM)

For Index = 1 To numberPayments

If Index < numberPayments Then
secondDur = couponRate * Index * _
(Index + 1) / (1 + YTM) ∧ Index + _
secondDur
Else
secondDur = (couponRate + 1) * _
Index * (Index + 1) _
/ (1 + YTM) ∧ Index + _
secondDur
End If

secondDur = secondDur
Next Index

End Function

We need three bonds in order to calculate a portfolio of bonds whose dura-

tion and whose second duration derivative are exactly equal to those of the
liability. The proportions of a portfolio which sets both the duration and its
second derivative equal to those of the liability are bond 1 = −0.5619, bond
3 = 1.6415, bond 4 = −0.0797.2 As the following figure shows, this portfolio
provides a better hedge against the terminal value than even bond 2:

2. See next subsection for the details of this computation.

549 Immunization Strategies

2,000
ImmunizaƟon Using Second DerivaƟves
1,950
1,900
1,850
1,800
1,750
1,700
1,650
1,600
1,550
1,500
0% 2% 4% 6% 8% 10% 12% 14% 16%

Bond 2 Bond porƞolio

Computing the Bond Portfolio

We want to invest proportions x1, x3, x4 in bonds 1, 3, and 4 so that:

• The portfolio is totally invested: x1 + x3 + x4 = 1.

• The portfolio duration is matched to that of bond 2: x1D1 + x3D3 + x4D4 =
D2, where Di is the duration of bond i.
• The second derivative of the portfolio duration is matched to that of bond
2: x1D12 + x3 D32 + x4 D42 = D22, where Di2 is the duration derivative.

Writing this in matrix form, we get:

⎡ 1 1 1 ⎤ ⎡ x1 ⎤ ⎡ 1 ⎤
⎢D D3 D4 ⎥ ⎢ x3 ⎥ = ⎢ D2 ⎥
⎢ 1 ⎥⎢ ⎥ ⎢ ⎥
⎢⎣ D12 D32 D42 ⎥⎦ ⎢⎣ x4 ⎥⎦ ⎢⎣ D22 ⎥⎦
550 Chapter 21

whose solution is given by:

−1
⎡ x1 ⎤ ⎡ 1 1 1 ⎤ ⎡ 1 ⎤
⎢x ⎥ = ⎢D D3 D4 ⎥ ⎢D ⎥
⎢ 3⎥ ⎢ 1 ⎥ ⎢ 2⎥
⎢⎣ x4 ⎥⎦ ⎢⎣ D12 D32 D42 ⎥⎦ ⎢⎣ D22 ⎥⎦

This can easily be set up in Excel:

I J K L M N
15 Calculating the bond portfolio:
16 Vector of
17 Matrix of coefficients constants
18 1 1 1 1
19 12.8964 10.8484 7.0539 10.0000
20 229.0873 148.7023 67.5980 110.0000
21
22 Solution
23 -0.5619
24 1.6415 <-- {=MMULT(MINVERSE(I18:K20),M18:M20)}
25 -0.0797

26
27
28 Explanation of the above: We want to invest proportions
29 x1, x3, and x4 in bonds 1, 3 and 4 respectively, in order
30 that: a) The total investment is $1000; this means x1+x2+x4=1
31 b) Portfolio duration is matched to that of bond 2; this means
32 that x1*D1+x3*D3+x4*D4 = D2, where Di is the duration
33 of bond I.
34 c) The weighted average duration derivatives are equal
35 to that of bond 2.
36
37 These three conditions give us the matrix system in
38 cells I18:K20 and the corresponding solution in
39 cells I23:I25 .
 551 Immunization Strategies

Given this solution, the last chart is produced by the following data table:

A B C D E F
Data table: Sensitivity of Bond 2 and bond Bond
Bond 2
26 portfolio terminal values to interest rate portfolio
27 <-- =I23*B23+I24*D23+I25*E23 , data table header (hidden)
28 0% $ 1,868.87 $ 1,774.63
29 1% $ 1,844.71 $ 1,781.79
30 2% $ 1,825.14 $ 1,786.37
31 3% $ 1,810.05 $ 1,789.02
32 4% $ 1,799.35 $ 1,790.32
33 5% $ 1,792.97 $ 1,790.78
34 6% $ 1,790.85 $ 1,790.85
35 7% $ 1,792.95 $ 1,790.91
36 8% $ 1,799.26 $ 1,791.31
37 9% $ 1,809.76 $ 1,792.38
38 10% $ 1,824.46 $ 1,794.38
39 11% $ 1,843.37 $ 1,797.58
40 12% $ 1,866.53 $ 1,802.21
41 13% $ 1,893.98 $ 1,808.46
42 14% $ 1,925.77 $ 1,816.55
43 15% $ 1,961.98 $ 1,826.65

21.6 Summary

The value of an immunized portfolio of bonds is insensitive to small changes

in the underlying yield to maturity of the bonds. Immunization involves setting
the bond portfolio’s duration equal to the duration of the underlying liability
against which the portfolio is held. This chapter shows how to effect the
immunization of the portfolio. Needless to say, Excel is an excellent tool for
immunization calculations.

Exercises

1. Prove that the duration of a portfolio is the weighted average duration of the portfolio
assets.

2. Set up a spreadsheet that enables you to duplicate the calculations of section 21.5 of this
chapter.

3. Using the example of section 21.5, find a combination of bonds 1 and 3 with a duration
of 8. Then find a combination of bonds 1 and 2 with a duration of 8.

4. In exercise 3, which portfolio would you prefer to immunize an obligation with a duration
of 8?

5. In exercise 3, recalculate the portfolio proportions assuming that you need a target duration
of 12. Which portfolio would you prefer now?