28 Nov
Immunization of Bonds | CA Final SFM
Investment in bonds cannot be considered completely risk free. Such investment can have the following two types of risk:
- Interest Rate Risk
- Reinvestment Risk
1. Interest Rate Risk
- Such risk arises when interest rate prevailing in market increases.
- This will cause an increase in the expectation for the bond holder.
- As a result, the discounting rate i.e. DYR increases and the present value of bond decreases.
2. Reinvestment Risk
- Such risk arises when interest rate prevailing in market decreases.
- As a result, the bond that is currently held will have increase in its value.
- However, once the bond is redeemed, the investor gets the redemption price in hand.
- The investment of such amount cannot be made at the earlier coupon rate and the reinvestment will be at a lower rate resulting into reduced income for the investor.
Immunization of bond is a process of creating a bond portfolio through which the interest rate risk and reinvestment risk can be either eliminated or minimized.
Note
Immunization cannot be achieved through single bond and creating a bond portfolio is necessary for immunization.
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