Immunization

Odile Brancusi must pay a lump-sum obligation in exactly eight years. Rather than spreading maturities across the next fifteen years, she buys a portfolio of high-grade corporate bonds that ALL mature in roughly eight years. This maturity structure is known as:

1. A.A laddered strategy.Wrong. A ladder spreads maturities evenly so that bonds come due each year. The stem expressly rejects that approach.
2. B.A bullet strategy.Correct. A bullet concentrates maturities at one point on the curve, chosen to match a known future obligation.
3. C.A barbell strategy.Wrong. A barbell holds very short and very long maturities with nothing in the middle. Odile has done the opposite - everything in the middle.
4. D.A rate anticipation swap.Wrong. A rate anticipation swap is an active trade based on a forecast of rate direction, not a description of a maturity structure.

Why: Concentrating maturities at a single point on the yield curve, chosen to coincide with a known future need, is a BULLET strategy. It maximises certainty about when the money arrives, at the cost of committing the whole portfolio to one point on the curve. Contrast the alternatives: a LADDER spreads maturities evenly across many years so that something matures each year; a BARBELL concentrates at the very short and very long ends with nothing in between. A rate anticipation swap is not a maturity structure at all - it is an active bet on the direction of rates.

The Ridgemont Pension Trust owes a fixed lump sum in exactly seven years and wants that payment insulated from interest rate movements. Its consultant assembles a bond portfolio whose DURATION equals seven years. This technique - immunization - works because:

1. A.Duration matching removes the credit risk of the bonds held in the portfolio.Wrong. Immunization addresses interest rate risk only. Credit risk is managed by issuer selection and diversification.
2. B.Price risk and reinvestment risk move in opposite directions, and setting duration equal to the horizon makes them approximately offset.Correct. That offsetting relationship is the entire mechanism behind immunization.
3. C.A seven-year duration guarantees that every bond in the portfolio matures on the obligation date.Wrong. Duration is a weighted average sensitivity measure, not a maturity date. Matching actual maturities to the liability is cash flow matching, a different technique.
4. D.A portfolio's duration is fixed once established, so an immunized portfolio never needs rebalancing.Wrong. Duration drifts as time passes and as rates move, so an immunized portfolio must be rebalanced to stay matched.

Why: Immunization exploits the fact that a change in rates hurts a bondholder in one way while helping in another. If rates RISE, bond prices fall (price risk), but coupons are reinvested at the new higher rates (reinvestment benefit). If rates FALL, prices rise but coupons are reinvested at lower rates. Setting portfolio duration equal to the investment horizon makes those two effects approximately cancel, so the accumulated value at the horizon date is roughly insensitive to rate changes. Because duration drifts as time passes and rates move, an immunized portfolio must be rebalanced periodically to keep duration aligned with the shrinking horizon.