Modern Security Analysis - 2

8/9/2019 Modern Security Analysis - 2

1/7

1 | P a g e

Question 1

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.

Briefly describe each of these four techniques;

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 cash-

matched dedicated portfolio.

iv.

Describe two parameters that should be specified when using contingent

immunization.

v.

Select one of the four alternatives techniques that you believe requires the least degree

of active management and justify your selection.

Answer:

i. a) Classical Immunization Theory depends heavily on the assumption that yield

curve shifts are parallel, which is not what happens in reality. Classical Immunization

formulates a bond immunization strategy to ensure funding of a predetermined

liability and evaluate the strategy under various interest rate scenarios.

According to classical immunization, if you set the effective duration of the bond

equal to the duration of the liability, youll be immunized from interest rate risk. It

also says as part of the process to set the Present Value of the bond equal to the

Present Value of the liability.

Classical is just matching the durations of assets to that of liabilities and it is

protected from a one-time shift in rates.


2/7

2 | P a g e

b) Contingent Immunization is a method of fixed income portfolio management,

whereby managers are granted significant powers of control over the selection of

products to be added and removed from the portfolio, as long as the products remain

profitable. In other hand, contingent immunization is a fund management strategy in

which the manager of a fund's portfolio replaces an active strategy with an

immunization strategy if the return on the portfolio falls to a certain point. If the

portfolio return remains above the point, the contingent immunization plan is not

needed and the manager will continue to use an active management strategy. If used,

the immunization strategy will hold assets and liabilities of equal risk and duration,

and allows the portfolio to return to a safety-net level return.

Contingent Immunization allows for profits and is triggered once you reach a

breakpoint.

c) Cash-Matched Dedication is a method by which the anticipated returns on an

investment portfolio are matched with estimated future liabilities. So that investment

earnings will provide funds for anticipated future capital outlays. Pension funds and

insurance companies can fairly accurately predict future liabilities, which tend to be

large. Their portfolios typically include low-risk, investment-grade securities, such as

medium- or high-rated bonds, that allow for fairly predictable earnings to match to

projected future capital outlays.

Cash-Matched Dedication-buy zero coupon bonds to mature at latest liability and

work backwards and is most conservative. Not immunization at all, just making sure

there will be enough cash flow to cover liabilities.

d)Duration-Matched Dedication is an immunization strategy in which one matches

the duration of assets in a portfolio to the duration of the liabilities. Duration is the

number of years until the investor receive the present value of all income from a bond

(including interest and principal), and is used to gauge a bond's sensitivity to interest

rate changes. A duration matching strategy is intended to reduce the portfolio's

sensitivity to interest rates in order to reduce the risk of loss to the holder.


3/7

3 | P a g e

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 buy-

and-hold strategy, by design the instruments best suited for this strategy are high-

grade 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.


4/7

4 | P a g e

iii. In creating a cash-matched dedicated portfolio, you need to consider the coming

major considerations involved which are:

1. Timing of initiation. Usually, the client wants to initiate the portfolio

immediately. Let the client prevail unless the portfolio manager considers a delay

advisable.

2.

Payments time intervals. Specify when the required payments are to be made

yearly, semiannually, or quarterly.

3.

What is your reinvestment rate assumption for the interim flows? You should be

very conservative in your estimate to avoid negative surprises.

Once the portfolio is established, the cash-matched dedicated portfolio probably

requires the least supervision over time. You do not have to rebalance the immunized

portfolio or adjust the duration of the duration-matched dedicated portfolio.

iv.

There are two parameters characterizing a given contingent immunization program

that serve to define where on the risk/return spectrum the program will be positioned,

as well as the degree of flexibility of the active management process. The two

parameters are:

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 datethat are the key sources of flexibility in a

contingent immunization procedure.


5/7

5 | P a g e

v. For my point of prospective, in Selecting the alternative technique that I believe

requires the least degree of active management. The selection will be Contingent

Immunization because Contingent Immunization is a method of fixed income

portfolio management, whereby managers are granted significant powers of control

over the selection of products to be added and removed from the portfolio, as long as

the products remain profitable. And for the active management theory says that, the

use of a human element, such as a single manager, co-managers or a team of

managers, to actively manage a fund's portfolio. Active managers rely on analytical

research, forecasts, and their own judgment and experience in making investment

decisions on what securities to buy, hold and sell. The opposite of active management

is called passive management, better known as "indexing".

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.


6/7

6 | P a g e

Question 2

Explain the following.

i. Bond convexity;

ii. Duration measures;

iii. Liquidity preference hypothesis; and

iv. Segmented market hypothesis

Answers:

i. Bond convexity is a measure of the sensitivity of the duration of a bond to

changes in interest rates, the second derivative of the price of the bond with

respect to interest rates (duration is the first derivative). In general, the higher the

convexity, the more sensitive the bond price is to the change in interest rates.

Bond convexity is one of the most basic and widely used forms of convexity in

finance.

In other words, Convexity describes the relationship between price and yield for a

standard, non-callable bond. Bond prices and yields move in opposite directions:

A bond's yield rises when its price falls, and falls when its price rises.

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.


7/7

7 | P a g e

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.

The market segmentation hypothesis explains the same phenomenon in terms of

differences in supply and demand between segments of the capital markets. Some

participants, such as banks, mainly borrow and lend short maturity securities.

Others, such as pension funds, are major participants in the long-term portion of

the yield curve. If more funds are available to borrow relative to demand in the

short-term market than in the long-term market, short-term interest rates will be

lower and long-term rates will be higher than predicted by both the expectations

and liquidity preference hypothesis. The drawback to this perspective is that it

does not explain very well the usual upward slope of the term structure, nor does it

provide a good explanation for the levels of intermediate-term rates. In addition,

the financial markets are not strictly segmented; many institutions issue and

purchase both short-term and long-term securities.

Documents

Modern Security Analysis - 2