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I'm trying to figure out some kind of immunization using a factor model I developed for interest rates. Here is the basic problem. Let's say that we have a bond portfolio containing $N$ bonds with weights $x_i$ and one liability. Call the present value of the liability $P_L$. I'll suppose that the bond prices are given by $$P_i=\Sigma_{t=1}^T F_{it}e^{-r_tt}$$ where $F_{it}$ is the future payoff of bond $i$ and $r_t$ is the interest rate at time $t$. Now the factor model for the term structure of the interest rates can be written $$\Delta r_t=\Sigma_{j=1}^k \beta_{jt} \Delta f_j +\epsilon_t$$ for $k$ independent factors and standard normal error term $\epsilon_t$. I'm assuming I have small but not necessarily parallel-shifts in the term structure, I want a first order condition for factor immunization. Can someone help?

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The present value is $$ P_i= \sum_{t=1}^T F_{i,t} \exp(-r_t t), $$ what happens if rates change to $r_t + \Delta r_t$ then the new price is $$ P_i^{new} = \sum_{t=1}^T F_{i,t} \exp(-(r_t+\Delta r_t) t). $$ by the exponential series $\exp(x)\approx 1 + x$ we can write $$ P_i^{new} - P_i =: \Delta P_i \approx -\sum_{t=1}^T F_{i,t} \Delta r_t t. $$ Observing the shifts in these rates we have some kind of key-rate duration setting.

If you can decompose your liablity $P_L$ in the is way too (denote the cash flows by $F_t$, then you can try to find quantities $Q_i$ such that $$ |\sum_{t=1}^T (Q_i F_{i,t} - F_t) \Delta r_t t| -> Min $$

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Usually the moviments in the yield curve are decomposed by level, slope and curvature or parallel, steepness and bends in the term structure. These 3 factors can explain over 95% 98% of the total variance. Sometimes a second curvature point is used and the explanation reaches 99%. Instead of approximate it numerically why won't you fit the Svensson or Nelson Siegel model and use it as your factors?

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  • $\begingroup$ I could fit some type of polynomial based factor model, but that's not my point. The question is, no matter what type of factor model you fit, how do you decide what amount of each bond to by so that you meet the liability and you are immune to changes in the factors. $\endgroup$ – Wintermute Jan 15 '15 at 14:48
  • $\begingroup$ You have to "moment match" then. So if your liability has a duration of X And your bond has a duration of y this ratio is the amount you held for that bond. And then you do for other factors $\endgroup$ – Tulio Carnelossi Jan 15 '15 at 14:53

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