what is immunization 
immunization also known as multi period immunization is a risk mitigation strategy that matches the duration of assets and liabilities in order to minimize the impact of interest rates on net worth over time understanding immunizationimmunization helps large firms and institutions protect their portfolios from exposure to interest rate fluctuations using a perfect immunization strategy firms can nearly guarantee that movements in interest rates will have virtually no impact on the value of their portfolios for example large banks must protect their current net worth whereas pension funds have the obligation of payments after a number of years these institutions are both concerned about protecting the future value of their portfolios and must deal with uncertain future interest rates immunization is considered a quasi active risk mitigation strategy because it 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 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 just like a vaccine immunizes a body against infection immunization leaves a portfolio safeguarded against interest rate fluctuations duration or the average life of a bond which is also its price sensitivity to changes in interest rates is commonly used in immunization it is a much more accurate predictive measure of a bond s volatility than a bond s term to maturity this strategy is commonly used in the institutional investment environment by insurance companies pension funds and banks to match the time horizon of their future liabilities with structured cash flows it is one of the most sound strategies and can also be used successfully by individuals for example just like a pension fund would use an immunization to plan for cash flows upon an individual s retirement that same individual could build a dedicated portfolio for their own retirement plan immunization can be accomplished by cash flow matching duration matching convexity matching and trading forwards futures and options on bonds similar strategies can be used to immunize other financial risks such as exchange rate risk often investors and portfolio managers use hedging techniques to reduce specific risks hedging strategies are usually imperfect but if a perfect hedging strategy is in place it is technically an immunization strategy immunization examplesassume an investor needs to pay a 10 000 obligation in five years to immunize against this definite cash outflow the investor can purchase a security that guarantees a 10 000 inflow in five years a five year zero coupon bond with a redemption value of 10 000 would be suitable by purchasing this bond the investor matches the expected inflow and outflow of cash and any change in interest rates would not affect their ability to pay the obligation in five years to immunize a bond portfolio using the duration method an investor must match the portfolio s duration to the investment time horizon in question if an investor has a 10 000 obligation in five years there are a few ways in which they can use duration matching it is possible to make a profit using duration matching all that needs to be done is to construct a bond portfolio in a way that the portfolio s convexity is higher than the convexity of the liabilities increasingly long term personal investments such as retirement accounts are immunized for example future liabilities are matched by fixed income portfolio duration choosing an immunization strategyportfolio immunization using duration and cash flow matching are two types of dedication strategies to safeguard the funding of liabilities when due immunization via duration matching aims to balance the opposing effects interest rates have on the price return and reinvestment return of a coupon bond a multiple liability immunization strategy pays off better when the interest rate shifts are not too arbitrary it requires a lower investment than cash flow matching but does carry reinvestment risk in the case of non parallel rate shifts cash flow matching on the other hand relies on the availability of securities with specific principals coupons and maturities to work efficiently this is far fetched in most practical cases and so this strategy requires more cash investment it also runs the risk of excess cash balances accumulating and being reinvested at very low rates in between liabilities due to these factors multiple liability immunization is generally superior to cash flow matching linear programming and optimization techniques are used to extend and even combine the two strategies in order to achieve even better results 