Active management strategies and contingent immunization.
Portfolio immunization is a strategy that insulates the portfolio from exposure to the interest rate risk which consists of price risk and reinvestment risk. Portfolio immunized enable the value of portfolio will not be influenced by the fluctuations of interest rate by adopting several strategies which including passive management strategies, active management strategies and contingent immunization.
Passive management strategy is a way that used to adjust the risk performance of a portfolio. Duration matching is undertaken in passive management which it used to reduce the duration GAP by matching the duration of assets equal to duration of liabilities in order to reduce the interest rate risk. Besides that, to protect the portfolio from potential risks, target date immunization adopted to equal the duration of bond same as investor's ideal holding period. Apart from that, cash flow matching and dedication strategy are another methods to immunize the portfolio from risks exposure. Cash flow matching is the firm expects the cash inflow match with cash outflow and it will not affect the payment obligation if there is a movement in interest rate whereas dedication strategy is a cash flow matching on a multi period basis. The advantage of dedication strategy is once the cash inflow match to cash outflow, rebalancing is unnecessary due to the elimination of interest rate risk occurred.
Active management is a strategy to foresee the movement of interest rate and analyze the market spread. Active bond portfolio management strategies comprise interest rate anticipation, valuation analysis, credit analysis, yield spread analysis and bond swap. For the interest rate anticipation, investor forecast the future interest rate under uncertainty condition. This strategy is useful to safeguard bond holders from encounter big losses when there is a sudden rise of interest rate. Investors able to alter the maturity and duration when they success to foresee the direction of interest rate. Bond with longer maturity and longer duration will benefit to bond holders when there is decrease of interest rate. On the other hand, they will shorten the duration of bond if the interest rate is expected to increase in future date. Therefore, the interest rate's movement and timing, the change of duration and maturity of bond are important to immunize the bond portfolio. Besides that, portfolio manager can assess the value of bond, they can either look for undervalued bond or sell the overvalued bond based on the valuation analysis. Credit analysis is the judgment of default risk which the bond holder fails to repay the debt obligation. Portfolio manager always keep track the credit analysis to verify the bond holders will not default in their payment. Apart from that, to immunize the portfolio, portfolio manager should monitor the yield relationship between varieties of bonds through yield spread analysis. This analysis is pursued when bond holder believe that the yield spread between two sectors of the bond market is temporary outperform. If the yield spread is narrow, the particular bond is doing better than other bond and investor will consider replacing the bond by the particular bond. Furthermore, bond swap can be adopted when investor believe that the market has temporarily mispriced two bonds. Investor can substitutes the particular bond with another identical bond with the equal coupon, maturity, quality, call features and so on.
Contingent immunization is a technique that incorporates the passive and active management strategy. It is a method that uses the active management as long as the return is above the minimum rate of return. If the minimum rate is less than the floor rate of return, immunization strategy is initiated and reaches the minimal acceptable performance.
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