Immunization (finance)

In finance, interest rate immunization is a portfolio management strategy designed to take advantage of the offsetting effects of interest rate risk and reinvestment risk.

In theory, immunization can be used to ensure that the value of a portfolio of assets (typically bonds or other fixed income securities) will increase or decrease by the same amount as a designated set of liabilities, thus leaving the equity component of capital unchanged, regardless of changes in the interest rate. It has found applications in financial management of pension funds, insurance companies, banks and savings and loan associations.

Immunization can be accomplished by several methods, including cash flow matching, duration matching, and volatility and convexity matching. It can also be accomplished by trading in bond forwards, futures, or options.

Other types of financial risks, such as foreign exchange risk or stock market risk, can be immunised using similar strategies. If the immunization is incomplete, these strategies are usually called hedging. If the immunization is complete, these strategies are usually called arbitrage.

Immunisation was discovered independently by several researchers in the early 1940s and 1950s. This work was largely ignored before being re-introduced in the early 1970s, whereafter it gained popularity. See Dedicated Portfolio Theory#History for details.

Frank Redington is generally considered to be the originator of the immunization strategy. Redington was an actuary from the United Kingdom. In 1952 he published his "Review of the Principle of Life-Office Valuations," in which he defined immunization as "the investment of the assets in such a way that the existing business is immune to a general change in the rate of interest." Redington believed that if a company (for example, a life insurance company) structured its investment portfolio assets to be of the same duration as its liabilities, and market interest rates decreased during the planning horizon, the lower yield earned on reinvested cash flows would be offset by the increased value of portfolio assets remaining at the end of the planning period. On the other hand, if market interest rates increased, the same offset effect would occur: higher yields earned on reinvested cash flows would be offset by a reduction in the value of the portfolio. In either scenario, with offsetting effects on each side of the balance sheet, the shareholders' equity value of the business would be immunized from the effect of changes in interest rates.

In 1971, Lawrence Fisher and Roman Weil framed the issue as follows: to immunize a portfolio, "the average duration of the bond portfolio must be set equal to the remaining time in the planning horizon, and the market value of assets must be greater than or equal to the present value of the liabilities discounted at the internal rate of return of the portfolio."

Pension funds use immunization to lock in current market rates, when they are attractive, over a specified planning horizon, and to fund a future stream of pension benefit payments to retirees. Banks and thrift (savings and loan) associations immunize in order to manage the relationship between assets and liabilities, which affects their capital requirements. Insurance companies construct immunized portfolios to support guaranteed investment contracts, structured financial instruments which are sold to institutional investors.