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Question 1

Your client wants to know the basic differences between (a) classical
immunization, (b) contingent immunization, (c) cash-matched dedication,
and (d) duration-matched dedication.
i.

Briefly describe each of these four techniques;

ii.

Briefly discuss the ongoing investment action you would have to carry out if
managing an immunized portfolio;

iii.

Briefly discuss three of the major considerations involved with creating a cashmatched dedicated portfolio.

iv.

Describe two parameters that should be specified when using contingent


immunization.

v.

Select one of the four alternatives techniques that you believe requires the least degree
of active management and justify your selection.

Answer:
i.

a) Classical Immunization Theory depends heavily on the assumption that yield


curve shifts are parallel, which is not what happens in reality. Classical Immunization
formulates a bond immunization strategy to ensure funding of a predetermined
liability and evaluate the strategy under various interest rate scenarios.
According to classical immunization, if you set the effective duration of the bond
equal to the duration of the liability, youll be immunized from interest rate risk. It
also says as part of the process to set the Present Value of the bond equal to the
Present Value of the liability.
Classical is just matching the durations of assets to that of liabilities and it is
protected from a one-time shift in rates.
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b) Contingent Immunization is a method of fixed income portfolio management,


whereby managers are granted significant powers of control over the selection of
products to be added and removed from the portfolio, as long as the products remain
profitable. In other hand, contingent immunization is a fund management strategy in
which the manager of a fund's portfolio replaces an active strategy with an
immunization strategy if the return on the portfolio falls to a certain point. If the
portfolio return remains above the point, the contingent immunization plan is not
needed and the manager will continue to use an active management strategy. If used,
the immunization strategy will hold assets and liabilities of equal risk and duration,
and allows the portfolio to return to a safety-net level return.
Contingent Immunization allows for profits and is triggered once you reach a
breakpoint.

c) Cash-Matched Dedication is a method by which the anticipated returns on an


investment portfolio are matched with estimated future liabilities. So that investment
earnings will provide funds for anticipated future capital outlays. Pension funds and
insurance companies can fairly accurately predict future liabilities, which tend to be
large. Their portfolios typically include low-risk, investment-grade securities, such as
medium- or high-rated bonds, that allow for fairly predictable earnings to match to
projected future capital outlays.
Cash-Matched Dedication-buy zero coupon bonds to mature at latest liability and
work backwards and is most conservative. Not immunization at all, just making sure
there will be enough cash flow to cover liabilities.

d) Duration-Matched Dedication is an immunization strategy in which one matches


the duration of assets in a portfolio to the duration of the liabilities. Duration is the
number of years until the investor receive the present value of all income from a bond
(including interest and principal), and is used to gauge a bond's sensitivity to interest
rate changes. A duration matching strategy is intended to reduce the portfolio's
sensitivity to interest rates in order to reduce the risk of loss to the holder.

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ii.

For managing the immunized portfolio you should follow the immunization strategy,
this strategy has the characteristics of both active and passive strategies. By
definition, pure immunization implies that a portfolio is invested for a defined return
for a specific period of time regardless of any outside influences, such as changes in
interest rates. Similar to indexing, the opportunity cost of using the immunization
strategy is potentially giving up the upside potential of an active strategy for the
assurance that the portfolio will achieve the intended desired return. As in the buyand-hold strategy, by design the instruments best suited for this strategy are highgrade bonds with remote possibilities of default. In fact, the purest form of
immunization would be to invest in a zero-coupon bond and match the maturity of
the bond to the date on which the cash flow is expected to be needed. This eliminates
any variability of return, positive or negative, associated with the reinvestment of
cash flows.

Normally, interest rates affect bond prices inversely. When interest rates go up, bond
prices go down. But when a bond portfolio is immunized, the investor receives a
specific rate of return over a given time period regardless of what happens to interest
rates during that time. In other words, the bond is immune to fluctuating interest
rates.

To immunize a bond portfolio, you need to know the duration of the bonds in the
portfolio so that the portfolio and adjust the portfolio so that the portfolios duration
equals the investment time horizon. For example, suppose you need to have $50,000
in five years for your childs education. You might decide to invest in bonds. You
can immunize your bond portfolio by selecting bonds that will equal exactly $50,000
in five years regardless of interest rate changes. You can buy one zero-coupon bond
that will mature in five years to equal $50,000, or several coupon bonds each with a
five year duration, or several bonds that :average a five-years duration.

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iii.

In creating a cash-matched dedicated portfolio, you need to consider the coming


major considerations involved which are:

1. Timing of initiation. Usually, the client wants to initiate the portfolio


immediately. Let the client prevail unless the portfolio manager considers a delay
advisable.
2. Payments time intervals. Specify when the required payments are to be made
yearly, semiannually, or quarterly.
3. What is your reinvestment rate assumption for the interim flows? You should be
very conservative in your estimate to avoid negative surprises.

Once the portfolio is established, the cash-matched dedicated portfolio probably


requires the least supervision over time. You do not have to rebalance the immunized
portfolio or adjust the duration of the duration-matched dedicated portfolio.

iv.

There are two parameters characterizing a given contingent immunization program


that serve to define where on the risk/return spectrum the program will be positioned,
as well as the degree of flexibility of the active management process. The two
parameters are:

1. The minimum return target, or more specifically the differences between the
minimum return target and the immunization return then available in the market.
2. The acceptable range for the terminal horizon date of the program. In other
words, a limited horizon range is used to replace the rigidly fixed horizon date
employed

in

conventional

immunization

programs.

Thus,

contingent

immunization requires that the manager meet the minimum return target (which
will be somewhat lower than the maximum rate currently available) over some
investment period that falls within the specified horizon range.
As well become evident, it is the loosening up of the two characteristic parameters
minimum return and a fixed horizon date that are the key sources of flexibility in a
contingent immunization procedure.
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v.

For my point of prospective, in Selecting the alternative technique that I believe


requires the least degree of active management. The selection will be Contingent
Immunization because Contingent Immunization is a method of fixed income
portfolio management, whereby managers are granted significant powers of control
over the selection of products to be added and removed from the portfolio, as long as
the products remain profitable. And for the active management theory says that, the
use of a human element, such as a single manager, co-managers or a team of
managers, to actively manage a fund's portfolio. Active managers rely on analytical
research, forecasts, and their own judgment and experience in making investment
decisions on what securities to buy, hold and sell. The opposite of active management
is called passive management, better known as "indexing".

Investment companies and fund sponsors believe it's possible to outperform the
market, and employ professional investment managers to manage one or more of the
company's mutual funds. The objective with active management is to produce better
returns than those of passively managed index funds. For example, a large cap stock
fund manager would look to beat the performance of the Standard & Poor's 500
Index. Unfortunately, for a large majority of active managers, this has been difficult.
This phenomenon is simply a reflection of how hard it is, no matter how smart the
manager, to beat the market. Thats why the contingent immunization fits the active
management more.

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Question 2
Explain the following.
i.

Bond convexity;

ii.

Duration measures;

iii.

Liquidity preference hypothesis; and

iv.

Segmented market hypothesis

Answers:

i.

Bond convexity is a measure of the sensitivity of the duration of a bond to


changes in interest rates, the second derivative of the price of the bond with
respect to interest rates (duration is the first derivative). In general, the higher the
convexity, the more sensitive the bond price is to the change in interest rates.
Bond convexity is one of the most basic and widely used forms of convexity in
finance.
In other words, Convexity describes the relationship between price and yield for a
standard, non-callable bond. Bond prices and yields move in opposite directions:
A bond's yield rises when its price falls, and falls when its price rises.

ii.

Duration measures are a measure of the sensitivity of the price (the value of
principal) of a fixed-income investment to a change in interest rates. Duration is
expressed as a number of years. Rising interest rates mean falling bond prices,
while declining interest rates mean rising bond prices.
The duration number is a complicated calculation involving present value, yield,
coupon, final maturity and call features. Fortunately for investors, this indicator is
a standard data point provided in the presentation of comprehensive bond and
bond mutual fund information. The bigger the duration number, the greater the
interest-rate risk or reward for bond prices.

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iii.

Liquidity preference hypothesis is the idea that investors demand a premium for
securities with longer maturities, which entail greater risk, because they would
prefer to hold cash, which entails less risk. The more liquid an investment, the
easier it is to sell quickly for its full value. Because interest rates are more volatile
in the short term, the premium on short- versus medium-term securities will be
greater than the premium on medium- versus long-term securities. For example, a
three-year Treasury note might pay 1% interest, a 10-year treasury note might pay
3% interest and a 30-year treasury bond might pay 4% interest.
A theory stating that, all other things being equal, investors prefer liquid
investments to illiquid ones. This is because investors prefer cash and, barring
that, prefer investments to be as close to cash as possible. As a result, investors
demand a premium for tying up their cash in an illiquid investment; this premium
becomes larger as illiquid investments have longer maturities. This theory is more
formally stated as: forward rates are greater than future spot rates. John Maynard
Keynes was the first to propose the liquidity preference hypothesis. See also:
Keynesian economics.

iv.

The market segmentation hypothesis explains the same phenomenon in terms of


differences in supply and demand between segments of the capital markets. Some
participants, such as banks, mainly borrow and lend short maturity securities.
Others, such as pension funds, are major participants in the long-term portion of
the yield curve. If more funds are available to borrow relative to demand in the
short-term market than in the long-term market, short-term interest rates will be
lower and long-term rates will be higher than predicted by both the expectations
and liquidity preference hypothesis. The drawback to this perspective is that it
does not explain very well the usual upward slope of the term structure, nor does it
provide a good explanation for the levels of intermediate-term rates. In addition,
the financial markets are not strictly segmented; many institutions issue and
purchase both short-term and long-term securities.

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