Bond Portfolio Immunization Example | How to Immunize bond portfolio | FIN-Ed

[Music] hi in this video I will explain how bond portfolio immunization technique is implemented by using a tuition liability example a bond portfolio or fixed obligation is subject to interest rate risk the bond value or any types of future obligation fluctuate with the change in interest rate in order to protect this portfolio values from changing in interest rate investors can implement immunization strategy which minimize such risk let's use tuition expenses as future fixed liability to illustrate how the duration and the interest rate risk can be managed for example you will be paying $10,000 a year in tuition expenses at the end of the next two years bonds currently yield 8% first question what is the present value in duration of your obligation the calculation looks like this in the table we used weighted average method to calculate duration since the tuition obligation has two years to maturity column 1 shows the two time period payments are in column two in column three we discount each of these payments by 8% YTM the sum is seventeen thousand eight thirty two point six five which is the present value of future tuition expenses in column for each number in column three is divided by the sum to calculate the weight for example divided nine thousand two fifty nine point two six by seventeen thousand eight thirty two point six five you get zero point five one nine two please make sure that the sum in column 4 is one in column five we multiply weight by time period example one times zero point five one nine two equals zero point five one nine two three finally the sum of column five is one point four eight zero seven seven hints the present value of your obligation is seventeen thousand eight thirty two point six five and that duration is one point four eight zero eight years second question what maturity zero coupon bond would immunize your obligation to immunize the obligation invest in a zero coupon bond maturing in one point four eight zero eight years which is exactly your duration of the application since the present value of this zero coupon bond must be equal to the present value of your tuition obligation which is seventeen thousand eight thirty two point six five the face value of the zero coupon bond must be seventeen thousand eight thirty two point six five times one point zero eight power one point four eight zero eight equals nineteen thousand nine eight five point two six question number three suppose you buy a zero coupon bond with value and duration equal to your obligation now suppose that rates immediately increase to nine percent what happens to your net position if the interest rate increases to nine percent the zero coupon bond would fall in value to nineteen thousand nine eighty five point two six divided by 1.09 to the power one point four eight zero eight which gives you seventeen thousand five ninety point nine to the present value of the tuition obligation would fall to seventeen thousand five ninety one point one one so that the net position changes by zero point one nine what if rates fall to seven percent if the interest rate falls to seven percent the zero coupon bond would rise in value two eighteen thousand seventy nine point nine nine the present value of the tuition obligation would increase to eighteen thousand eighty point one eight so that the net position changes by zero point one line only please note that your net position is only zero point one line or they get less of the change in interest rate in summary although your future tuition obligation changes because of changing interest rate you are not affected by this change because of the immunization strategy you have in place thanks for watching

Channel: FIN-Ed

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Keywords: FIN-Ed, fined, bond immunization, bond portfolio, change in bond price, bond duration, weighted duration, weighted average duration, dollar weighted duration, Duration, macaulay duration, bond investment, interest rate risk, bond price sensitivity, bond value and interest rate, bond, corporate finance, finance, bond immunization example, financial education, bond portfolio immunization, bond portfolio immunization example

Id: Dp7Dgu8hr_o

Length: 5min 8sec (308 seconds)

Published: Sun Apr 14 2019