7. IM Insurance wish to hedge themselves against interest rate risk by ensuring

Question

7. IM Insurance wish to hedge themselves against interest rate risk by ensuring that the average duration of their assets equals the average duration of their liabilities. This strategy is known as duration matching or portfolio immunization. Explain how duration matching can protect a portfolio of assets and liabilities against a shift in interest rates.

8. Describe a situation when the duration of assets doesn’t match the duration of liabilities. When do you make a profit (loss) on your portfolio?

9. In which situation does duration matching fail to perfectly immunize a portfolio?

Explanation / Answer

7. Duration matching is a strategy used to minimize the risk of portfolio. Since duration is a measure in determining a bond's sensitivity to interest rates, duration matching is used to manage a portfolio so that changes in interest rates will influence price and reinvestment risk at the same rate, hence, keeping the portfolio's rate of return constant.

Since price and reinvestment risk is at the same rate, the portfolio is maintained at same level of risk which is against shift in interest rates

8. Duration matching cannot protect a portfolio from some kinds of financial risks such as Default. If a borrower has defaulted the payment, then portfolio will go for a toss and the strategy of duration matching fails. In this case there is a loss on the portfolio.

The disadvantage associated with duration matching is that it assumes the durations of assets and liabilities remain unchanged, which is rarely the case.

9. If a borrower has defaulted an interest payment of a bond then the bond price will decline which changes the duration of the bond. This makes duration of assets not equal duration of liabilities. The strategy will fail.

Related Questions

Navigate

• Browse (All)
• Browse 7
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.