Why must an immunized portfolio be rebalanced periodically?

What will be an ideal response?

The key to immunizing a portfolio of assets is to match the duration of the assets with the liabilities. Because market yields can change periodically affecting the duration of the assets, the portfolio of assets must be rebalanced periodically to insure immunization. More details are given below.

Illustrations of the principles underlying immunization often assume a one-time instantaneous change in the market yield. In practice, the market yield will fluctuate over the investment horizon. As a result, the duration of the portfolio will change as the market yield changes. In addition, the duration will change simply because of the passage of time.

Even in the face of changing market yields, a portfolio can be immunized if it is rebalanced so that its duration is equal to the duration of the liability's remaining time. For example, if the liability is initially 5.5 years, the initial portfolio should have a duration of 5.5 years. After six months the liability will be five years, but the duration of the portfolio will probably be different from five years. This is because duration depends on the remaining time to maturity and the new level of yields, and there is no reason why the change in these two values should reduce the duration by exactly six months. Thus the portfolio must be rebalanced so that its duration is five years. Six months later the portfolio must be rebalanced again so that its duration will equal 4.5 years. And so on.

There is the question of how often the portfolio should be rebalanced to adjust its duration. On the one hand, the more frequent rebalancing increases transactions costs, thereby reducing the likelihood of achieving the target yield. On the other hand, less frequent rebalancing will result in the duration wandering from the target duration, which will also reduce the likelihood of achieving the target yield. Thus the portfolio manager faces a tradeoff in that some transactions costs must be accepted to prevent the duration from straying from its target, but some adjustment in the duration must be accepted or transactions costs will become prohibitively high.