QUESTION 6: IMMUNIZATION

(a) Suppose you have a single-payment liability that is due in 7 years' time (i.e. at t=7) and that the yield curve is currently flat at 7% pa.You set up an immunizing portfolio today.In lectures, we discussed the two conditions necessary to determine an immunization portfolio.

(a) (i)The first condition says that the Present Value of the Liability should equal the Present Value of the Immunizing Portfolio.Explain why this condition is necessary.

(a) (ii)The second condition says that the Macaulay Duration of the Liability should equal the Macaulay Duration of the Immunizing Portfolio.Explain why this condition is necessary.In your answer, you may refer to interest rate risk and reinvestment risk.

(b) (i)What is meant by rebalancing of an immunization portfolio?

(b) (ii)Why is it necessary to occasionally rebalance an immunization portfolio even if the two immunizing conditions are satisfied when you first set up the portfolio?