Required Reading for Chapter 8 in Actuarial Risk Management I [STAT40450] Shane Whelan, 2009

Derivation of the Three Conditions for Redingtons Immunisation

The theory behind Redingtons immunisation assumes: (i) a level yield curve that moves continuously with t. (ii) all liability outgoes are known in timing and amountsay, Lt at time t. For simplicity we shall assume further that Lt is not a function of i, the interest rate. (iii) all asset proceeds are known in timing and amountsay, At at time t. Again, for simplicity, we shall assume that At is not a function of i, the interest rate. The present value of the liabilities is given by VL=vtLt at ruling rate of interest on market. Similarly, the present value of the assets is given by VA= vtAt. The three condition for Redingtons immunisation are: I: VL=VA PV of liabilities = PV of assets, at market rate of interest II: (tvtLt)/(vtLt) = (tvtAt)/(vtAt) Discounted mean term of assets equals the discounted mean term of liabilities. III:(t2vtLt)/(vtLt) < (t2vtAt)/(vtAt) The spread of the liability proceeds about its mean term is less than that of the asset proceeds. Derivation: Let f (i ) = V A VL . Apply Taylors Expansion:

f (i + ) = f (i ) + f (i ) +

f (i ) + ...

So, if we set I: f (i ) = 0 II: f (i ) = 0 and III: f (i ) > 0 Then, for small , f (i + ) > f (i) = 0. Hence portfolio is immunised against a small change in the ruling interest rate, i.e., present value of assets will not be lower than present value of the liabilities at the new ruling interest rate i + . Below we show that conditions I, II, and III correspond to conditions I, II, and III respectively.

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Required Reading for Chapter 8 in Actuarial Risk Management I [STAT40450] Shane Whelan, 2009

Condition I is just a normalising condition, i,e. true by fiat. I I. For II. Consider II. We want to select assets such that f (i ) = 0 . But

f (i ) =

d ( At Lt )vt ) di t 0
t 0

= ( At Lt )
t 0

d t v di

= ( At Lt )(t )vt +1
Condition II: f (i ) = 0 implies that Or, equivalently,

( A L )(t )v
t t t 0

t +1

= 0.

(t ) A v
t t 0 t t 0

t +1

= (t ) Lt v t +1
t 0 t 0

tAt v = tLt v t
Dividing the right and left side above by VL=VA

tA v Av
t t 0 t t 0

tL v = L v
t t 0 t t 0

This is condition II. Finally, for III, consider the third requirement under Taylor, III: f (i ) > 0 We have
f (i ) = d2 ( At Lt )v t ) 2 di t 0

d2 t = ( At Lt ) 2 v di t 0 d = ( At Lt ) (t )v t +1 di t 0 = ( At Lt )(t )(t 1)v t +2

t 0

= ( At Lt ).t.(t + 1).v t +2
t 0

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Required Reading for Chapter 8 in Actuarial Risk Management I [STAT40450] Shane Whelan, 2009

Accordingly, f (i ) > 0 implies Hence

( A L ).t.(t + 1).v
t t t 0

t+2

>0.

A .t.(t + 1).v
t t 0

t +2

> Lt .t.(t + 1).v t +2

t 0

A .(t
t t 0

+ t ).v t > Lt .(t 2 + t ).v t , by multiplying both sides by (1 + i ) 2 .

t 0 t t

But, by condition II, Hence

tA v = tL v
t t t 0 t 0

A .t
t t 0

.v t > Lt .t 2 .v t
t 0

Once again, dividing the right and left side above by VL=VA, we arrive at:

A .t .v Av
2 t t 0 t t t 0

L .t .v > Lv
2 t t 0 t t t 0

And this is condition III, which concludes the derivation.

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