The Immunization Problem - Illustrated for the 30-year bond

Buy $1,014
face value
of 30-year
bond.

Year 10:
Future obligation of
$1,790.85 due.

Reinvest
coupons from
bond during
years 1-10.

Sell bond for PV of

remaining coupons
and redemption in
year 30.

When the interest rate increases:

Value of
reinvested
coupons
increases.

Value of bond in
year 10 decreases.

When the interest rate decreases:

Value of
reinvested
coupons
decreases.

Value of bond in
year 10
increases.

30

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Basic Immunization Example with One of 3 Bonds

Future Obligation
Yield to maturity
Maturith
Present Value of the Obligation

Coupon rate
Maturity
Face value

$1,790.85
6%
10
<-- =B3/(1+B4)^B5, The amount of investment
Bond 1
6.70%
10
$1,000

Bond 2
6.988%
15
$1,000

Bond 3
5.90%
30
$1,000

Bond price
Units of Bond bought
Face value of $1,000 investment
Settlement date
Maturity date

<-- =PV($B$4,D10,-D9*D11,-D11)
<-- =$B$6/D13
<-- =D14*D11
<-- =DATE(2014,11,3)
<-- =DATE(YEAR(D16)+D10,MONTH(D16),DAY(D16))

Right After Investing in the Bond

New yield to maturity

6%
Bond 1

Bond 2

Bond 3

Bond price at Year 10

Reinvested coupons
Total

<-- =PV($B$21,D10-$B$5,-D9*D11,-D11)
<-- =FV($B$21,$B$5,-D9*D11)
<-- =D24+D25

Terminal Value

<-- =D14*D26

Data Table: Bond Value

Sensitivity
to Interest Rate

Bond 1

Bond 2

Bond 3
<-- =D28 , data table header (hidden)

0%
1%

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UN-16C

2%
3%
4%
5%
6%
7%
8%
9%
10%
11%
12%
13%
14%
15%

Terminal Value

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$2,000.00
$1,900.00
$1,800.00
$1,700.00
$1,600.00
$1,500.00
$1,400.00
$1,300.00
$1,200.00
$1,100.00
$1,000.00
$900.00
$800.00
$700.00
$600.00
$500.00
$400.00
$300.00
$200.00
$100.00

Immunization Properties of the Three Bonds

Bond 1
Bond 2
Bond 3

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$100.00
$0.00

0%

2%

4%

6%Interest
8% Rate10%

12%

14%

Page 4

16%

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Immunization with Convexity Maximization

Future Obligation
Yield to maturity (YTM)
Maturity
Present Value of the Obligation

$1,790.85
6%
10
<-- =B3/(1+B4)^B5, The amount of investment
Bond 1
6.70%
10
$1,000

Coupon rate
Maturity
Face value
Bond price
Units of Bond bought
Face value of $1,000 investment
Beginning date
Ending date

Bond 2
6.988%
15
$1,000

Bond 3
5.90%
30
$1,000

2014-Nov-03 2014-Nov-03 2014-Nov-03

Duration

<-- =DURATION(D16,D17,D

New YTM

6%

Bond 1
23
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Bond 2

Bond 3

Bond
Portfolio (1
& 3)

Bond price
Reinvested coupons
Total
Terminal Value
Portfolio of Bonds 1 and 3
Proportion of Bond 1
Proportion of Bond 3

<-- =(B5-D19)/(B19-D19)
<-- =1-B31

Bond 1
Interest Rate
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%

Page 5

Bond 2

Bond 3

Bond
portfolio

Pages 545, 546

A
11%
12%
13%
14%
15%

$1

Immunization Performance
Bond 2 versus Bond Portfolio

$1

Terminal Value

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$1
$1

Bond 2
Bond Portfolio

$0
$0
$0
0%

2%

4%

6%

8%

Interest Rate

Page 6

10%

12%

14%

16%

Pages 545, 546

1
2
3
4
5
amount of investment
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<-- =DURATION(D16,D17,D9,$B$4,1)
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28 <-- =B31*B28+(1-B31)*D28
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36 <-- =E26, Data Table Header
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Bond 2
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Bond Portfolio
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Page 8

Immunization with Matching the 2nd Derivatives

Future Obligation
Yield to maturity
Maturity
Present Value of the Obligation

Coupon rate
Maturity
Face value

$1,790.85
6%
10 years
$1,000
Bond 1
4.50%
20
$1,000

Bond 2
6.988%
15
$1,000

Bond 3
3.50%
14
$1,000

Bond 4
11.00%
10
$1,000

Bond price
Units of Bond bought
Face value equal to $1,000 of market value
Beginning date
Ending date

2014-Nov-03 2014-Nov-03 2014-Nov-03 2014-Nov-03

Duration
Second derivative of duration
New yield to maturity

6%
Bond 1

Bond 2

Bond 3

Bond 4

Bond price
Reinvested coupons
Total
Product

Data Table: Sensitivity of Bond 2 and Bond

Portfolio terminal values to interest rate

Bond 2

Bond
Portfolio
<-- =I31*B30+I32*D30+I33*E30

0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
11%
12%
13%
14%
15%

<-- =PV($B$4,E10,-E9*E11,-E11)
<-- =$B$6/E13
<-- =E14*E11
<-- =DATE(2014,11,3)
<-- =DATE(YEAR(E17)+E10,MONTH(E17),DAY(E17))
<-- =DURATION(E17,E18,E9,$B$4,1)
<-- =W24
Weights of the Bond Portfolio
Matrix of coefficients
1
1

<-- =PV($B$23,E10-$B$5,-E9*E11,-E11)
<-- =FV($B$23,$B$5,-E9*E11)
<-- =E26+E27
<-- =E14*E28

Solution

<-- =MMULT(MINVERSE(I26:K28),

- =I31*B30+I32*D30+I33*E30

Immunization Using

2nd

Derivative

1
1
1

Explanation of the above: We want to invest pr

x1, x3, and x4 in bonds 1, 3 and 4 respectively, i

that: a) The total investment is $1000; this me

b) Portfolio duration is matched to that of bond
that x1*D1+x3*D3+x4*D4 = D2, where Di is the du
of bond I.
c) The weighted average duration derivatives a
to that of bond 2.

These three conditions give us the matrix syste

cells I26:K28 and the corresponding solution in
cells I31:I33 .

0
0
0
0%

2%

4%

6%

8%

10%

12%

14%

16%

0%

2%

4%

6%
Bond 2

8%

10%
Portfolio

12%

14%

16%

Calculating the 2nd Derivative of Duration

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Vector of
constants
1
<-- =B5
<-- =B5*(B5+1)

LT(MINVERSE(I26:K28),M26:M28)

ove: We want to invest proportions

1, 3 and 4 respectively, in order

estment is $1000; this means x1+x2+x4=1

s matched to that of bond 2; this means
4 = D2, where Di is the duration

age duration derivatives are equal

s give us the matrix system in

corresponding solution in

C1,t

C2,t

C3,t

C4,t

<-- =B$9*B$11
<-- =(1+B$9)*B$11
Second derivative of duration -->

t(t+1)PV(C1,t)

t(t+1)PV(C2,t)

t(t+1)PV(C3,t)

t(t+1)PV(C4,t)

<-- =$O23*($O23+1)*P23/(1+$B$4)^$O23
<-- =SUM(W4:W23)/E13