An evaluation of contingent immunization Antonio Díaz a , María de la O González a , Eliseo Navarro a , Frank S. Skinner b, * a Departamento de Análisis Económico y Finanzas, Universidad de Castilla-La Mancha, Facultad de CC Económicas y Empresariales de Albacete, Plaza de la Universidad, 1, 02071 Albacete, Spain b University of Surrey, School of Management, Guildford, Surrey GU2 7XH, United Kingdom article info Article history: Received 23 January 2008 Accepted 16 April 2009 Available online 22 April 2009 JEL classification: C61 E43 G11 G12 Keywords: Immunization Contingent immunization Active portfolio management abstract This paper tests the effectiveness of contingent immunization, a stop loss strategy that allows portfolio managers to take advantage of their ability to forecast interest rate movements as long as their forecasts are successful, but switches to a pure immunization strategy should the stop loss limit be encountered. This study uses actual daily transactions in the Spanish Treasury market covering the period 1993–2003 and uses performance measures that accounts for skewness and kurtosis as well as mean variance. The main result of this paper is that contingent immunization provides excellent performance despite its simplicity. Crown Copyright Ó 2009 Published by Elsevier B.V. All rights reserved. 1. Introduction The aim of this research is to test the effectiveness of contingent immunization techniques. The pioneer works in this field, Leibo- witz and Weinberger (1981, 1982, 1983), developed contingent immunization as a midpoint in a risk-return framework between pure immunization and active bond management strategies. Con- tingent immunization is a stop loss strategy that allows portfolio managers to take advantage of their ability to forecast interest rate movements as long as their forecasts are successful, but switches to a pure immunization strategy should the stop loss limit be encountered. Specifically, contingent immunization consists of forming a bond portfolio with a duration larger or smaller than the investor’s planning period depending on interest rate expecta- tions. If the investor thinks that interest rates are going to rise more than the market expects she would buy a bond portfolio with a duration smaller that her planning period and vice versa. How- ever, if interest rates move opposite to the investor’s expectations and the portfolio value falls to a given stop loss limit then she would immunize and guarantee this lower limit for the eventual portfolio return. This strategy gives contingent immunization an option like feature: 1 limiting losses but preserving upside potential if interest rates movements are favourable. Therefore contingent immunization strategies represent an attempt to capture positive (or avoid negative) skewness. While prior work is supportive of immunization, the accuracy of the results is affected by the assumption that portfolio weights are adjusted periodically rather than when a payment is made from the underlying portfolio. For instance, Fooladi and Roberts (1992) and Ventura and Pereira (2006) assume semi-annual rebal- ancing while Soto (2001, 2004) assumes quarterly adjustments. Late rebalancing can lead to poor results because immunization can be applied late after the stop loss limited is violated. Late rebalancing therefore can have an important impact on the assess- ment of contingent immunization as a viable strategy especially if interest rates fluctuate sharply as in the case of the Spanish market during the period 1993–1998. This paper makes a number of contributions. First this paper makes a high computational effort in measuring the holding period returns of all strategies as realistic and exact as possible by rebal- ancing the portfolio each time payments are due instead of period- ically and checking the portfolio value every day to determine whether the stop loss rule should be implemented. Consequently this paper makes the most accurate assessment of contingent immunization to appear in the literature so far. 0378-4266/$ - see front matter Crown Copyright Ó 2009 Published by Elsevier B.V. All rights reserved. doi:10.1016/j.jbankfin.2009.04.008 * Corresponding author. Tel.: +44 148 368 6364; fax: +44 148 368 6346. E-mail addresses: Antonio.Diaz@uclm.es (A. Díaz), MariaO.Gonzalez@uclm.es (María de la O González), Eliseo.Navarro@uclm.es (E. Navarro), F.Skinner@surrey. ac.uk (F.S. Skinner). 1 In particularly it could be compared to a synthetic call option. Journal of Banking & Finance 33 (2009) 1874–1883 Contents lists available at ScienceDirect Journal of Banking & Finance journal homepage: www.elsevier.com/locate/jbf