The concept of immunization was pioneered by F.M. Reddington (1952), who defined immunization as the investment of the assets in such a way that the existing business is immune to a general change in the rate of interest. As an example of the principles underlying the immunization of a portfolio against expected changes in interest rate;

Consider a life insurance company that sells a guaranteed investment contract (GIC) that guarantees an interest rate of 6.25% every 6 months (12.5% on a bond equivalent yield (BEY) basis) for 5.5 years. Suppose that the policyholder (the manager of an employee retirement fund, i.e., a pension fund company) made a payment of $8,820,262. The value that the life insurance company has guaranteed is:

$17,183,033 = $8,820,262 x (1.0625)¹¹

The portfolio manager of the life insurance company must now invest the principal ($8,820,262) with the goal of realizing the promised amount at the agreed time period. S/he, the portfolio manager, has select 4 bonds from a bond universe that could likely fund this liability of

$17, 183,033 at the end of 5.5 years.

Bond Option A: Buy a 12.5% coupon bond that matures in 5.5 years when the markets yield is 12.5%. If market yield changes just after the bond was issued and stays at the new level for the remainder of the 5.5 years.