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Finance, Economics, and Mathematics by Robert C. Merton, Oldrich A. Vasicek

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Chapter 23A Risk Minimizing Strategy for Portfolio Immunization

By H. Gifford Fong and Oldrich A. Vasicek

Journal of Finance 39, No. 5, 1541–1546, 1984.

Abstract

Consider a fixed-income portfolio whose duration is equal to the length of a given investment horizon. It is shown that there is a lower limit on the change in the end-of-horizon value of the portfolio resulting from any given change in the structure of interest rates. This lower limit is the product of two terms, of which one is a function of the interest rate change only and the other depends only on the structure of the portfolio. Consequently, this second term provides a measure of immunization risk. If this measure is minimized, the exposure of the portfolio to any interest rate change is the lowest.

Introduction

The traditional theory of immunization as formalized by Fisher and Weil (1971) defines the conditions under which the value of an investment in a bond portfolio is protected against changes in the level of interest rates. The specific assumptions of this theory are that the portfolio is valued at a fixed horizon date, that there are no cash inflows or outflows within the horizon, and that interest rates change only by a parallel shift in the forward rates. Under these assumptions, a portfolio is said to be immunized if its value at the end of the horizon does not fall below the target value, where the target value is defined as the portfolio value at the horizon date under the scenario of no change ...

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