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Immunization: To immunize a portfolio, you need to know the duration of the bonds and adjust the portfolio so the duration is equal to the investment time horizon. For example, you might select bonds that you know will return $10,000 in five years time regardless of interest rate changes. Normally, when interest rates go up, bond prices go down. But if a portfolio is immunized, the investor receives a specific rate of return over time regardless of what happens to interest rates, because the portfolios duration is equal to the investors time horizon. This means any changes to interest rates will affect the bonds price and reinvestment at the same rate, keeping the rate of return steady. Maintaining an immunized portfolio means rebalancing the portfolios average duration every time interest rates change, so that the average duration continues to equal the investors time horizon.
measured convexity when there is no expected change in future cash flows, or effective convexity, which is the convexity measure for a bond for which future cash flows are expected to change. The notion of bond convexity should not be confused with the convexity of the yield curve (see Term Structure of Interest Rates). The latter can assume an arbitrary shape (although a normal yield curve has negative convexity), and complex stochastic models have been proposed for its evolution.
More Info
Article:
Radcliffe, Brent. Immunization inoculates against interest rate risk. Investopedia. Online at: www.investopedia.com/articles/financial-theory/09/bond-interest-rate-immunization.asp
Website:
This Matter on duration and convexity: thismatter.com/money/bonds/duration-convexity.htm
See Also
Checklists The Bond Market: Its Structure and Function Calculations Current Price of a Bond
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