Definition
Immunization locks in a target rate of return regardless of interest rate movements by matching the portfolio's duration to the liability or investment horizon. When rates rise, coupon reinvestment gains offset capital losses; when rates fall, capital gains offset reinvestment losses. This technique is fundamental to liability-driven investing used by pension funds and insurance companies.
lightbulb Example
A pension fund must pay $100M in 8 years. They immunize by building a bond portfolio with duration of 8 years and present value of $100M/(1+r)^8. Rate changes that hurt the bonds' price are offset by improved reinvestment returns.
verified_user Key Points
- Matches duration to liability time horizon
- Rate changes create offsetting gains and losses
- Requires periodic rebalancing as duration changes
- Foundation of liability-driven investing