Immunization Presented by : Patel Mitalee S.(32) Submitted to: Ms.Rutvi Sarang.

Immunization What Immunization mean????? Dictionary meaning of immunization – 1.naturally resistant to an infection 2.not affected 3.exepted or protected In financial term, immunization is a technique that makes the bond portfolio holder to be relatively certain about the promised stream of cash flow. A technique of investing in bonds such that the portfolio's target return is protected against interest rate fluctuations. Changes in returns at which cash flows can be reinvested are offset by changes in the value of the securities in the portfolio

Immunization Few definition related to Immunization Bond-A bond is the contract that requires the borrower to pay interest income to the holder. Coupon rate -Most of the bonds makes the payment till the maturity.This specific rate of interest is known coupon rate. it paid quarterly, semi-annually,and annually.At the end of maturity period,the value is repaid. Bond risk- risk associated to the bond portfolio are Interest rate, default, marketability and callability risk.

Immunization Risk associated to the bond portfolio: Interest rate risk- variability in the return is caused by the changes in the market interest rate. This is known as interest rate risk. Bond interest rate risk- it means risk associated to the bond. It arises from the changes in the market interest rate.. The market rate affect the coupon rate and price of the bond.

Immunization Immunization process In immunization process,the coupon rate risk and the price risk can be made to offset each other. Whenever there is an increase in market interest rate, the prices of the bond fall. At the same time coupon can be reinvested in the bond offering higher inerest rate and losses due to the fall in the price of bond can be offset and the portfolio is said to be immunized.

Immunization Immunization process: Market interest rate Bond interest rate Coupon rate risk Price risk Investor’s bond portfolio

Immunization i The bond portfolio manager or investor has to calculate the duration of the promised outflow of the funds and invest in a portfolio of bonds which has an identical duration. the bond portfolio duration is the weighted average of duration bonds in the portfolio, For example: if an investor has invested equal amount of money in 3 bonds namely A,B,C with duration of 2,3,4,years respectively, then the bond portfolio duration is, D=(1/3 x 2)+(1/3 x 3)+ (1/3 x 4) =(0.66)+1+(1.33) =2.99 (or)3 years

Immunization By matching the outflow duration with cash inflow duration from bond investment the bond manager can offset the interest risk and price risk. The portfolio of money to be invested between the different types of bonds also can be found. The equation is, Investment outflow=(X1xd1)+(X2xd2) X1,X2 =proportion of investment on bond 1and 2

Immunization Example on Immunization Ex.Abhisekh has 50,000 to make one time investment.His son has entered the Higher Secondary school and he needs his money back after two years for his son’s educational expenses. As Abhisekh’s outflow is one time outflow, duration is simply 2 years. Now he has choice of 2 types of bonds. 1)BOND A has a coupon rate of 7% and maturity period of 4 years with current yield of 10%.current price is Rs. 2)BOND B has a coupon rate of 6% and maturity period of 1years with current yield of 10%.current price is Rs

Immunization Solution Abhisekh can solve the problem by investing part of the money in 1 year bond and part in 4 year bond.But he should know how much to be invested in each of this bond. This can be got by solving the following Equation, (X1xd1)+(X2xd2)=2 That is X1,X2 are the proportion of investment in bond A and B respectively. d1,d2 are the duration of bond A and B respectively.

Immunization D2=1 B’z Bond B makes one time payment so 1 year bond is only one year investment. D1=? Equation D=Σpv(Ct) x t po YearCashflow Ct PVF (10%) Pv(Ct) (pv(Ct) po (pv(Ct) x t) po Po=904.89d1=3.6029

Immunization Applying the formula, (X1xd1)+(X2xd2)=2 X1 can be written as (1-X2) X2? d1= d2=1 After put all these data in to equation We will get X2=61.53% X1=38.42% Abhisekh should put 61.53% of his investible funds in 1 year bond and 38.42% in the 4 year bond.

Immunization For investing in both the bonds he needs, P.v= 50,000 (1+0.10)^2 = Rs. The money to be invested is, 1 year bond=Rs x X1=Rs x =Rs 25, year bond =Rs x X2=Rs x =Rs 15, How many bonds abhisekh can buy: 1 Year bond price year bond price Rs /963.64=26.4≈26 bondsRs / =17.54 ≈18bonds

Immunization According to the theory of immunization the rise in the market interest is offset by the reinvestment of matured bonds at a higher rate of interest. Theoretically it seems to be very simple, but in practice it is not so simple b’z of following reasons: 1)Immunization and duration are based on the assumption that the change in the interest rate would occur before payments are received from both the bonds. This may not be true always. The shift may occur after receiving the cashflow. 2)Another assumption is that the bonds have same yield. This also not be applicable. The yield my vary according to the period of maturity. 3)It is assumed that the shift in the interest rate affects all the bonds equally. Many a time, the shift in interest rates affects different bonds differently. 4)The whole analysis is based on the belief that there will not be any call risk or default risk. But evidence has proved that bonds investment is not free from call risk or default risk.

Immunization Thank you