B04 Duration hedging and immunization

Two liabilities and two zero-coupon bonds trade over four periods. The position is to hold its value when rates change.

Objective

Hold a position whose value survives a change in rates. Assessed on final wealth.

What it shows

• Duration as a number that matches assets to liabilities.
• Immunization: choosing bonds so a rate move changes both sides equally.
• Why two bonds are needed for two liabilities.

Watch out for

• Matching the size of a liability and not its timing.
• A hedge that works in period one and drifts as time passes.
• A hedge that matches today's duration and not the duration a period later.

Who takes part

• Trader — every student. Trades LIAB1 and LIAB2, two liabilities, and ZERO2 and ZERO3, zero-coupon bonds of two and three years.

Class size

Ten to forty students in one role. Each trades against the room, so the larger the class the tighter the bond prices.