G.3.2 Full Immunization and Dedication

Question 1

what is full immunizaiton?

Answer 1

Full Immunization will protect the surplus from any size of
changes in the interest rate.

Question 2

what are the assumptions and conditions of full immunization?

Answer 2

Assumptions:
– flat yield curve, i.e. all spot rates the same.
– only parallel shifts in the yield curve.

Conditions for Full Immunization
1. PA = PL
2. ModD_A = ModD_L or equivalently MacD_A = MacD_L
3. Asset CFs must occur both before and after liability CFs.

Question 3

what is rebalancing?

Answer 3

Adjusting assets to maintain immunization. Immunization may not last w/o adjustments

Question 4

what are weaknesses to rebalancing?

Answer 4

– Rebalancing carries costs.

– More frequent rebalancing vs. Less useful immunization

– We assumed a flat yield curve, which is not generally the case.

– We assumed that when the yield changes, it has the same
change in yield for all terms (i.e., a “parallel shift”). Again, not
generally true.

• Liability cash flows may not be completely known — the
  amount or the timing or both may be unknown. (Think:
  insurance payout.)

– Assets with the needed maturities may not be available,
particularly for very long terms.

Question 5

what is dedication?

Answer 5

Dedication is immunization by exact matching.

Each asset cash flow is “dedicated” to a single liability.
CF_A received -> immediately pays CF_L

Question 6

what are the weaknesses of dedication?

Answer 6

1. Timing or size of liability CFs may be uncertain
2. Assets to exactly match liabilities may not be available
3. Might ignore higher yield opportunity
4. Asset CFs may not be exactly predictable (think: callable
   bonds, early repayment of loans)