Reviewed by Aug 27, 2020| Updated on
Introduction to Immunization
Immunization, also termed as multi-period immunization, is a risk-mitigation strategy that matches liability and asset lengths, bringing down the impact of interest rates on net worth over time. Large banks, for example, have to protect their current net worth, while pension funds have a payment obligation after a number of years. Both these entities are concerned with protecting the future value of their investments and must deal with future unpredictable interest rates.
Long-term personal assets such as retirement accounts are increasingly immuni zed where future liabilities equal the length of a fixed fund income.
How Does Immunization Function?
Immunization helps big companies and institutions protect their portfolios from exposure to fluctuations in interest rates. Using a great immunization policy, companies can almost guarantee that interest rate fluctuations would essentially have no impact on the value of their portfolios.
Immunization is called a "quasi-active" strategy for risk mitigation since it has both the features of active and passive strategies. By definition, pure immunization implies investing a portfolio for a given return over a specific period of time irrespective of any outside factors, such as interest rate changes.
Just as a vaccine vaccinates a body against infection, immunization leaves a portfolio protected from interest rate fluctuations.
Immunization can be achieved through matching cash flow, duration, convexity, and forward trading futures and options on bonds. Similar strategies can be used to vaccinate other financial risks, such as the risk of the exchange rate. The hedging strategies are often used by investors and portfolio managers to reduce particular risks. Hedging strategies are usually imperfect, but if a perfect hedging strategy is in place, it is an immunization strategy on a technical level.
The downside to a portfolio's immunization would forego the risk of opportunity if the assets were to increase in value while the liabilities still did not rise in the same way.