Assess ways of funding one future liability with a bond portfolio
The idea
The classic approach is immunisation. The bond portfolio's market value must at least equal the liability's present value, its Macaulay duration must equal the time to the payment date, and its convexity should be as low as possible while still exceeding the liability's. Matching duration means that for a parallel yield shift, the change in reinvestment income offsets the change in bond prices, locking in the portfolio's yield. Minimising convexity keeps cash flows close to the horizon, limiting structural risk. Duration drifts over time, so rebalancing is needed. The simplest alternative is a zero-coupon bond maturing on the date. The trap is thinking any duration-matched mix works equally: a barbell carries more structural risk than a bullet.
In the app: 2 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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