Introduction

Bond portfolio immunization and dedication are two widely used methods for controlling interest-rate risk, see, e.g., Platt (1986), Bierwag (1987), Fabozzi and Pollack (1987) and chapter 1 in this volume. The two approaches are seemingly very different. Under the immunization scheme, interest-rate risk is controlled by matching durations on assets and liabilities. When the interest rate moves, both sides of the balance sheet are affected in the same manner, leaving net present value virtually unaltered. Under the dedication scheme, the aim is to match cashflows to a degree which is economical under particular reinvestment and borrowing assumptions. As long as reinvestment rates do not fall below the scenario rates and borrowing rates do not rise above the ones assumed, the strategy ensures that enough cashflow is generated to gradually withdraw liabilities as they occur.

Which strategy should a particular investor choose? The traditional answer is that an immunized portfolio is riskier than a dedicated portfolio, hence also promises higher returns. If the investor is willing to accept some risk, he should establish an immunized portfolio, otherwise he should dedicate. However, this answer leads to additional questions. For example, to decide on the strategy, the investor may wish to know which risks are assumed in immunization, how large they are, and whether they agree with the investor's market views.