Five-star Bank is a regional bank in New South Wales. It has immunized the payment of a future liability by making an investment in a coupon bond. The duration of the bond matches that of the liability. Which of the following statements is TRUE if the immunization is effective?

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BlackTom AI · Accepted Answer

Let's break down the question by examining what immunization means in this context and then evaluate each statement.
Option A: 'Since the maturity of the bond decreases as time passes, the value of the bond increases irrespective of the changes in interest rate.' This is not a general rule of immunization. While duration changes over time as a bond approaches maturity, bond prices do not automatically rise regardless of interest-rate movements. Price behavior depends on yield changes and the bond's duration; the statement overstates a universal price increase and ignores interest-rate risk.
Option B: 'When the interest rate changes, the losses or gains from the bond when it is sold will be exactly offset by the gains or losses on reinvested coupon payments received on the bond.' This captures the essence of classical immunization: by matching the asset's duration to the liability, the sensitivity of the bond's price to interest-rate moves is offset by the effect of reinvesting coupons at the new rates, so the net effect on the funded position is protected against small parallel shifts in the yield curve. In other words, both price changes and reinvestment income move in a way that can cancel each other out, given effective immunization.
Option C: 'The bank needs to hedge the interest rate risk using derivative transactions to avoid losses.' Immunization aims to reduce the need for active hedging by structuring the asset and liability so that duration and cash flows align. While derivatives can hedge, a true immunization strategy seeks to minimize residual risk without relying on additional hedges. Therefore this statement contradicts the essence of immunization when it is effective.
Option D: 'The value of the liability will also fall if the bond price falls.' This mixes concepts. The liability’s value is date- and rate-sensitive, but the purpose of immunization is to ensure that changes in asset value and reinvestment performance offset changes in the liability’s value. Simply stating that the liability falls with bond price misses the balancing mechanism of the immunization scheme and is not an accurate description of the immunization effect.
Option E: 'The cash flows from the bond are fixed irrespective of the changes in interest rate.' While coupon payments are fixed, the total value of the bond and the realized value of reinvested coupons depend on prevailing interest rates. The statement ignores the price sensitivity of the bond to rate changes and the impact of reinvestment rates, which are central to immunization effects. Hence it is misleading.
In summary, option B correctly describes the immunization effect: with duration-matched assets and liabilities, interest-rate moves create offsetting changes between the bond’s value at sale and the reinvested coupon outcomes, protecting the funded position against small rate shifts. The other options either misstate how bond prices respond to rate changes, mischaracterize the purpose of immunization, or ignore the role of reinvestment income in the overall risk profile.

Five-star Bank is a regional bank in New South Wales. It has immunized the payment of a future liability by making an investment in a coupon bond. The duration of the bond matches that of the liability. Which of the following statements is TRUE if the immunization is effective?

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