Chapter 3 - Protecting investors against changes in interest rates

Abstract

This chapter aims to give a comprehensive presentation of the immunization problem, and to provide novel, original results. It shows that it is possible to protect investors against any change in the term structure of interest rates, and we will suggest a method to achieve this. It explains what is at stake. What are the exact consequences of a rise in interest rates? For a bond holder, is it good or bad news? The answer to this question depends crucially on the horizon of the investor. It is easy to figure out that an investor with a short horizon will suffer from a rise in interest rates because the bond (or bond portfolio) will immediately decrease in value, and this capital loss may not be compensated by the reinvestment of coupons at a higher rate. On the other hand, an investor with a longer horizon may welcome such a rise in interest rates for the two reasons: the initial capital loss will start eroding as bond prices return to their par value, and coupons will be reinvested at a higher rate. In the world of fixed exchange rates which followed the Bretton-Woods agreements, it was only natural that interest rates remained relatively stable. When that state of affairs was disrupted some three decades later, volatile interest rates transformed so-called fixed income assets into risky investments. It is at that time that considerable research was undertaken to protect institutional investors against the fluctuations of interest rates and of bond prices. The word "immunization" describes the steps taken by a bond manager to build up a portfolio which will be minimally sensitive to interest rate shifts.