Introduction

Traditionally portfolio immunization has referred to the problem of finding a set of bonds whose present value matches that of a predefined set of liabilities. This problem arises, for example, in the context of pension fund management where one seeks a way of investing a portion of a fund in a manner that will protect its value relative to the fund's projected liabilities. In this way, regardless of external factors such as interest-rate changes, the fund's assets and liabilities will have similar values. Any surplus funds may then be used to ensure capital growth.

In the early 1980s an extremely volatile interest-rate environment and high levels of interest rates gave prominence to models for portfolio immunization. In particular, pension fund managers found that they were valuing assets and liabilities inconsistently. The effect was dramatic when short-term rates approached 20% whereas internal actuarial discount rates were conservatively set to approximately 5%.

Since that time the use of “proper evaluation techniques” has been legislated in the United States and, more recently, in certain European countries as well. Optimization models for portfolio immunization are now used routinely for managing fixed-income portfolios.

It is curious to note that immunization models are almost identical across investment banking environments.