What is a key challenge of immunizing a single liability?

Immunizing a single liability involves matching the interest rate sensitivity of assets with that of the liability to mitigate interest rate risk. A key challenge in this process is that the durations of assets fluctuate with changes in interest rates. This variability can complicate the matching process because as interest rates change, the durations of both assets and liabilities can change as well.

When interest rates rise, the duration of fixed income bonds generally decreases. If the duration of the assets decreases more significantly than that of the liability, the immunization strategy may become ineffective, leading to potential shortfalls. This fluctuation means that the asset-liability matching can be disrupted, posing a challenge to maintaining an effective immunization strategy.

Overall, understanding how the durations of assets respond to changes in interest rates is essential for managing risk effectively when immunizing liabilities.