Overview
Immunization is the process of managing a portfolio that is designed to meet a set of future obligations in such a way that the ability of the portfolio to meet those obligations is not materially affected by changing interest rates.
Cash Flow Matching
Cash flow matching is the safest method of immunization, and the simplest from a mathematical perspective, although it may be hard to implement in practice. The process begins by making a list of the future cash obligations that the analyst needs to pay. Next, the analyst looks for fixed income instruments that produce cash amounts that match the size and date of the given liabilities.
As a simple example, given a list of dates and cash amounts, the analyst could buy zero coupon bonds that mature on each given date, with a principal equal to the cash obligation.
Duration Matching
The second common method of portfolio immunization is duration matching. In duration matching, the analyst constructs a portfolio that has a market value equal to the discounted value of the liabilities with a duration equal to the duration of the liabilities.
Next, as interest move, the analyst rebalances the portfolio to have a duration that matches the new duration of the liabilities. The process is designed to keep the market value of the portfolio equal to the market value of the liabilities. Of course, the two portfolios will not have the same cash flow dates, however, because they are equal in value, the analyst can always sell part of the portfolio to meet her obligations.