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Your client wants to know the basic differences between (a) classical
immunization, (b) contingent immunization, (c) cash-matched dedication,
and (d) duration-matched dedication.
i.
ii.
Briefly discuss the ongoing investment action you would have to carry out if
managing an immunized portfolio;
iii.
Briefly discuss three of the major considerations involved with creating a cashmatched dedicated portfolio.
iv.
v.
Select one of the four alternatives techniques that you believe requires the least degree
of active management and justify your selection.
Answer:
i.
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ii.
For managing the immunized portfolio you should follow the immunization strategy,
this strategy has the characteristics of both active and passive strategies. By
definition, pure immunization implies that a portfolio is invested for a defined return
for a specific period of time regardless of any outside influences, such as changes in
interest rates. Similar to indexing, the opportunity cost of using the immunization
strategy is potentially giving up the upside potential of an active strategy for the
assurance that the portfolio will achieve the intended desired return. As in the buyand-hold strategy, by design the instruments best suited for this strategy are highgrade bonds with remote possibilities of default. In fact, the purest form of
immunization would be to invest in a zero-coupon bond and match the maturity of
the bond to the date on which the cash flow is expected to be needed. This eliminates
any variability of return, positive or negative, associated with the reinvestment of
cash flows.
Normally, interest rates affect bond prices inversely. When interest rates go up, bond
prices go down. But when a bond portfolio is immunized, the investor receives a
specific rate of return over a given time period regardless of what happens to interest
rates during that time. In other words, the bond is immune to fluctuating interest
rates.
To immunize a bond portfolio, you need to know the duration of the bonds in the
portfolio so that the portfolio and adjust the portfolio so that the portfolios duration
equals the investment time horizon. For example, suppose you need to have $50,000
in five years for your childs education. You might decide to invest in bonds. You
can immunize your bond portfolio by selecting bonds that will equal exactly $50,000
in five years regardless of interest rate changes. You can buy one zero-coupon bond
that will mature in five years to equal $50,000, or several coupon bonds each with a
five year duration, or several bonds that :average a five-years duration.
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iii.
iv.
1. The minimum return target, or more specifically the differences between the
minimum return target and the immunization return then available in the market.
2. The acceptable range for the terminal horizon date of the program. In other
words, a limited horizon range is used to replace the rigidly fixed horizon date
employed
in
conventional
immunization
programs.
Thus,
contingent
immunization requires that the manager meet the minimum return target (which
will be somewhat lower than the maximum rate currently available) over some
investment period that falls within the specified horizon range.
As well become evident, it is the loosening up of the two characteristic parameters
minimum return and a fixed horizon date that are the key sources of flexibility in a
contingent immunization procedure.
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v.
Investment companies and fund sponsors believe it's possible to outperform the
market, and employ professional investment managers to manage one or more of the
company's mutual funds. The objective with active management is to produce better
returns than those of passively managed index funds. For example, a large cap stock
fund manager would look to beat the performance of the Standard & Poor's 500
Index. Unfortunately, for a large majority of active managers, this has been difficult.
This phenomenon is simply a reflection of how hard it is, no matter how smart the
manager, to beat the market. Thats why the contingent immunization fits the active
management more.
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Question 2
Explain the following.
i.
Bond convexity;
ii.
Duration measures;
iii.
iv.
Answers:
i.
ii.
Duration measures are a measure of the sensitivity of the price (the value of
principal) of a fixed-income investment to a change in interest rates. Duration is
expressed as a number of years. Rising interest rates mean falling bond prices,
while declining interest rates mean rising bond prices.
The duration number is a complicated calculation involving present value, yield,
coupon, final maturity and call features. Fortunately for investors, this indicator is
a standard data point provided in the presentation of comprehensive bond and
bond mutual fund information. The bigger the duration number, the greater the
interest-rate risk or reward for bond prices.
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iii.
Liquidity preference hypothesis is the idea that investors demand a premium for
securities with longer maturities, which entail greater risk, because they would
prefer to hold cash, which entails less risk. The more liquid an investment, the
easier it is to sell quickly for its full value. Because interest rates are more volatile
in the short term, the premium on short- versus medium-term securities will be
greater than the premium on medium- versus long-term securities. For example, a
three-year Treasury note might pay 1% interest, a 10-year treasury note might pay
3% interest and a 30-year treasury bond might pay 4% interest.
A theory stating that, all other things being equal, investors prefer liquid
investments to illiquid ones. This is because investors prefer cash and, barring
that, prefer investments to be as close to cash as possible. As a result, investors
demand a premium for tying up their cash in an illiquid investment; this premium
becomes larger as illiquid investments have longer maturities. This theory is more
formally stated as: forward rates are greater than future spot rates. John Maynard
Keynes was the first to propose the liquidity preference hypothesis. See also:
Keynesian economics.
iv.
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