Classic immunization or single period immunization is a really important concept. However, it does have some weaknesses in that it is not a simple Buy and Hold strategy and the portfolio does need frequent rebalancing.
There are however some extensions to Classic immunization starting with multiple liability immunization.
Classic immunization just protects Us Against One future liability. However, this can be extended to multiple liabilities and the concept still works as long as we match the duration of the portfolio of liabilities to the duration of the portfolio of bonds that we're holding. We should still be protected against interest rates changing. However, we do have one additional constraint in addition to the weighted average duration of the liability matching that wasted average duration of bond portfolio or assets. And that constraint is that the portfolio of bonds must have individual bonds who have durations that are both shorter and longer than the range of durations of the liabilities. So the range of the bond or asset durations must be wider than the range of the liability durations. With that extra constraints we can still follow an immunize the approach for a number of liabilities. Next we have return maximization classic immunization involves buying a number of bonds such that the duration of the bond portfolio perfectly matches the duration of the liability. However, no consideration is taken for the return that that portfolio will generate. It might be the case that we think we can do better in terms of generating return than following that pure immunization approach whilst taking on the risk. That this portfolio that is being invested into generate return might not generate the return we're expecting. If it does generate the return we're expecting that is more return than the immunized portfolio. We might end up with more cash than we need on the day when the liability Falls due because we've invested in bonds that generated higher returns. So the return maximization approach effectively says, well, let's follow that return maximization strategy, but we have a backstop which says if we end up in a position where we perform badly on those assets that we've invested in we want to always be able to revert to an immunized strategy if necessary. So what we're going to do is identify what market value of bonds we would need to purchase to be able to follow an immunized strategy. And if our portfolio falls close to that value, we would then revert to an immunized strategy to reduce the likelihood of not meeting the liability.
And finally, we've got Horizon matching. Cash flow matching is a more straightforward approach in that. We don't need to worry about rebalancing the portfolio. It's a straightforward Buy and Hold approach, but It suffers from the weakness of their only being a narrow range of bonds that can be used to meet the liabilities that need to be met duration has much more flexibility in terms of the bonds that can be invested in but does need to be rebalanced. So what some liability matching portfolios do is a mix of the two. sometimes referred to as Horizon matching But near term liabilities we use cash flow matching. But then for longer term liabilities where they may not be so many bonds available. We use the approach that gives us more flexibility in terms of which bonds we can hold. Which means we would use duration for those longer term liabilities.
