<\/span><\/h2>\nAlso known as length matching strategy, immunization is a blend of active and passive investment tactics. It helps in removing the danger of changing interest rates by matching the length of the portfolio to the investor\u2019s investment horizon. This strategy focuses on achieving the needed level of return by making investments with the intention of earning a specific amount by the end of a specific time.<\/p>\n
Bonds have both interest-rate risk and reinvestment risk, which share an inverse relationship to each other. When one increases, the other decreases. Interest rate risk increases with an increase in rates, whereas reinvestment risk decreases. Bond prices rise as interest rates fall, but the bonds’ cash flows can only be reinvested at a lower rate without assuming greater risk. Cash flow matching has the drawback that, if bonds are held until maturity, any reinvestment risk cannot be compensated by higher bond prices.<\/p>\n
Hence reinvestment is necessary. For instance, Rs 1000 placed in a savings account that yields 6% compounded semi-annually would yield Rs 806.11 after 10 years, whereas a 6% coupon bond with a par value of Rs 1000 would yield only Rs. 600 after 10 years. Therefore, to earn a 6% return with a coupon bond, the coupon must be reinvested.<\/p>\n
<\/span>4.1 CLASSICAL IMMUNIZATION<\/strong><\/span><\/h3>\nClassical immunisation entails building a bond portfolio so that it will generate a minimal return independent of fluctuations in interest rates. A few conditions must be met for the immunisation method to work, including: no defaults; asset prices must only fluctuate in response to interest rates (bonds, for example, cannot include embedded options); and yield curve shifts must be parallel.<\/p>\n