Chapter 11, Problem 8CP

Summary Introduction

(a)

To describe:

The components of interest rate risk. Also, explain the two risks faced by the holder of a bond.

Introduction:

Interest rate risk affects the return on investments in stocks and bonds. It has a significant effect only on bonds. It has two components namely, Price risk and reinvestment risk.

Summary Introduction

(b)

To determine:

What is immunization and why a bond manager would immune his or her portfolio.

Introduction:

Bond immunization is primarily an investment strategy. It is utilized by the bond manager for minimizing the interest rate risk of bond investments. As per this strategy, the time period of the portfolio with regards to the investment time of the investor is adjusted. Bond immunization functions in the way that the bond manger locks in a fixed rate of return during the investor's investment duration and does not cash the investment but rather holds it.

Summary Introduction

(c)

To determine:

The reason for which a duration matching strategy is a superior technique to a maturity matching strategy for the minimization of risk

Introduction:

Maturity matching is also known as hedging approach. It is a strategy of working capital financing which works on the principal that short term requirements are met with short-term debts and long-term requirements with long-term debts.