Sensitivity-Based Bond Portfolio Immunization with Nonparametric Term Structure Models

The traditional approach to bond portfolio immunization usually assumes that the possible future changes of the term structure of interest rates lie within a suitable parametric class of functions. The quantities of interest are the sensitivities of the portfolio value with respect to these parameters. Various kinds of term structure assumptions give rise to different bond portfolio immunization models—from the classical duration to key rate and parametric duration hedging. We propose a nonparametric version of this approach by introducing a suitable regularization—effectively imposing smoothness constraints on the term structure changes. This allows us to derive hedging equations without recourse to any specific parametric form. We test the proposed nonparametric immunization approach and find it performs slightly better than a traditional approach based on a popular Nelson-Siegel term structure parametric form