Fixed Income Analysis, Second Edition

CHAPTER 19

PORTFOLIO IMMUNIZATION AND CASH FLOW MATCHING

I. INTRODUCTION

In this chapter we will explain strategies for managing bond portfolios to satisfy predetermined liabilities. The two strategies we will discuss are immunization and cash flow matching. Immunization is a hybrid strategy having elements of both active and passive strategies. It is used to minimize reinvestment risk over a specified investment horizon. Immunization can be employed to structure a portfolio designed to fund a single liability or multiple liabilities. Cash flow matching is used to construct a portfolio that will fund a schedule of liabilities from a portfolio’s cash flows, with the portfolio’s value diminishing to zero after payment of the last liability.

II. IMMUNIZATION STRATEGY FOR A SINGLE LIABILITY

Classical immunization can be defined as the process by which a bond portfolio is created to have an assured return for a specific time horizon irrespective of interest rate changes.²⁹⁵ The fundamental principle underlying immunization is to structure a portfolio that balances the change in the value of the portfolio at the end of the investment horizon with the return from the reinvestment of portfolio cash flows (both coupon and principal payments). That is, immunization offsets interest rate risk and reinvestment risk. The general principle of immunization is summarized in Exhibit 1.

To accomplish this balancing requires controlling portfolio duration. By setting the portfolio duration ...