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BOND MATH: The Theory Behind the Formulas by Donald J. Smith

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Classic Immunization Theory

A great example of a passive fixed-income strategy is immunization. The objective is to try to lock in a target rate of return over a known investment horizon. This is accomplished by balancing the two opposing sources of interest rate risk over the holding period—cash flow reinvestment risk (on coupon and principal received prior to the horizon) and market price risk (on bonds that need to be liquidated at the horizon). If rates rise and remain risen, the future value of reinvested cash flow goes up but the sale price on the remaining bonds goes down. If, however, rates fall and remain fallen, the future value of reinvested cash flow goes down but the sale price on the remaining bonds goes up. As you no doubt are ...

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