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: Individual

Tgl Penyerahan

: 26 April 2014

Mata Kuliah : MKIL

Dosen: Dr. Ir. Perdana Wahyu Santosa. MM

Sasha Dhita



What is Immunization?
According to Fogler (1984), immunization is a set of rules that is being used for the purpose of
minimizing the impact of a change in interest rate of a financial wealth. It begins by assuming that an
investors present portfolio wealth is the difference between the present value of the expected future cash
inflows and cash outflows for a finite horizon. Bond portfolio managers are often required to promised
certain cash payments at a given time. If an investment in a bond portfolio deliver a payoff the from bond
that is equal to the desired payoff at the end of the holding period regarless of a variation in interest rate,
the bond portfolio is immunized. In other words, it locks a fixed rate of return during a given time
horizon, that is the amount of time that the investor wish to keep the money invested without withdrawing
Figure 16.10 Immunization (Bodie et al. 2011)

The figure above shows that the coupon bonds fully funded at 8%. The present value of curves are
tangent at 8%, hence the obligation will remain fully funded even if theres a slight change in interest
Duration is used to determine how a bond will react to changing interest rates. It measures a bonds
market risk and price volatility in response to a given change in interest rates. It is the weighted average
of the bonds cash flows over its lifetime. The weights are the present value of each interest payment as a

percentage of the bonds full price. Further, the longer the duration of a bond, the greater its price
Variations on Immunization
When a series of a promised cash commitments have to be met, such as to pay for college tuition,
a parent might construct a bond portfolio so that the interest and principal payments will be paid each year
when the tuition is due. The bonds have to be invested so that the series of promised payments equal to
the cash flows from the investment. Such an investment portfolio is known as dedicated portfolio. To
deal with this portfolio, an immunization technique known as cash matching has to be adopted (Bodie
et al., 2011). For example, the figure below shows how immunization works with coupon bonds.
Figure 1 How Immunization Works with Coupon Bonds

Let time to maturity of bond = N, c = coupons, V = value of bond at time T.

Suppose a fixed cash payouts is required at time T. This means that the bond must provide a fixed
payment over the period 0 to T, regardless the changes in interest rate in the interim period. The total
return from the bond over the T period consists of: (i) the return from reinvestment of the interim coupons
and (ii) proceeds from the sale of the bond, V at time T. When the interest rate increase, the value of the
bond V decreases (the general idea of bond pricing is that value of a bond has an inverse relationship with
the interest rate). When the interest rate increase, the coupons be reinvested at a higher rate and hence
increases the interest earned. Further, when the interest rate decrease, the bond value increases and the
coupons can only be reinvested at the new lower rate. If these two opposing effects exactly match each
over the period T, the return from the bond is unchanged and hence the bond is immunized over the time
period T. Moreover, this can be done by selecting a bond (or bond portfolio) with a duration equal to T.

Bodie, Z., Kane, A., and Marcus, A. (2011). Investments. 11 th edn. McGraw-Hill.
Fogler, H.R. (1984), Bond Portfolio Immunization, Inflation, and the Fisher Equation, Journal of Risk
and Insurance (pre-1986), pg. 244.