Immunization of Fixed-Income Portfolios Using an Exponential Parametric Model* Bruno Lund** Caio Almeida*** Abstract Litterman and Scheinkman (1991) showed that even a duration immunized fixed-income portfolio (neutral) can bear great losses and, therefore, propose hedging the portfolio using a principal component's analysis. The problem is that this approach is only pos- sible when the interest rates are observable. Therefore, when the interest rates are not observable, as is the case of most international and domestic debt markets in many emerging market economies, it is not possible to apply this method directly. The present study proposes an alternative approach: hedging based on factors of a parametric term structure model. The immunization done using this approach is not only simple and efficient but also equivalent to the immunization procedure proposed by Litterman and Scheinkman when the rates are observable. Examples of the method for hedging and leveraging operations in the Brazilian inflation-indexed public debt securities market are presented. This study also describes how to construct and to price portfolios that repli- cate the model risk factors, which makes possible to extract some information on the expectations of agents in regards to future behavior of the interest rate curve. Keywords: Fixed Income, Term Structure, Asset Pricing, Inflation Expectation, Immu- nization, Hedge, Emerging Markets, Debt, Derivatives. JEL Codes: E43, G12, G13. *Submitted in ??. Revised in ??. **Securities, Commodities and Futures Exchange { BM&FBovespa, Brazil. E-mail:
[email protected] ***Funda¸c~aoGetulio Vargas, EPGE/FGV, Brazil. Caio Almeida thanks CNPq for the research productivity grant. E-mail:
[email protected] Brazilian Review of Econometrics v.