[1] In theory, immunization can be used to ensure that the value of a portfolio of assets (typically bonds or other fixed income securities) will increase or decrease by the same amount as a designated set of liabilities, thus leaving the equity component of capital unchanged, regardless of changes in the interest rate.
It has found applications in financial management of pension funds, insurance companies, banks and savings and loan associations.
Redington believed that if a company (for example, a life insurance company) structured its investment portfolio assets to be of the same duration as its liabilities, and market interest rates decreased during the planning horizon, the lower yield earned on reinvested cash flows would be offset by the increased value of portfolio assets remaining at the end of the planning period.
Banks and thrift (savings and loan) associations immunize in order to manage the relationship between assets and liabilities, which affects their capital requirements.
Insurance companies construct immunized portfolios to support guaranteed investment contracts, structured financial instruments which are sold to institutional investors.
[9] Withdrawals from the portfolio to pay living expenses represent the stream of expected future cash flows to be matched.
Individual bonds with staggered maturities are purchased whose coupon interest payments and redemptions supply the cash flows to meet the withdrawals of the retirees.
Immunization requires that the average durations of assets and liabilities be kept equal at all times.
Coupon income, reinvestment income, proceeds from maturities and sales proceeds must be reinvested in securities that will keep the portfolio's duration equal to the remaining years in the planning period.
However, as Dr. Frank Fabozzi points out, the Macaulay duration metric and immunization theory are based on the assumption that any shifts in the yield curve during the planning period will be parallel, i.e. equal at each point in the term structure of interest rates.
Using that knowledge, an immunized portfolio can be created by creating long positions with durations at the long and short end of the curve, and a matching short position with a duration in the middle of the curve.
[citation needed] Immunization can be done in a portfolio of a single asset type, such as government bonds, by creating long and short positions along the yield curve.