Cash flow matching is better than multiple liability immunization.

The concepts of immunization and cash flow matching come into play when we talk about the asset-liability portfolio management approach.Cash flow matching and immunization are two types of dedication strategies.

When a portfolio is constructed with the purpose of funding specific future liabilities, there is a risk of the portfolio value not meeting the target value when the liabilities become due.The strategy to overcome and minimize this risk is portfolio immunization.

To immunize a portfolio, we have to match the duration of assets with future liabilities.There is a tradeoff between price risk and reinvestment risk in a fixed-income portfolio.There is a relationship between price risk and return.

The price of a coupon bond falls when interest rates go up.In case of a parallel interest rate shift once the portfolio is set up, the aim of immunization is to establish a portfolio in which the two components of total return are offset by each other.Matching the duration of the portfolio with the horizon of future liability is how this is done.

A two-year bond with a 6% coupon payable semi-annually that is selling at par value of $1,000 is yielding 6%.The time horizon for such a bond is one year.

Let's take a look at three different scenarios of interest rates after the bond is purchased.In Scenario 1 there is no change in rates, while in Scenario 2 and 3 there are rates of 8% and 4%.

The duration of the bond or portfolio of bonds must be set at 1.There is no net change in total return when the durations are matched.

The duration of the bond was 1.91 and the portfolio return was different depending on the interest rate shifts.It is important that the liability duration is matched with the portfolio duration at all times in order to achieve immunization.

Classical single-period immunization is what this case is called.When an investor has to fund a stream of future liabilities, this approach is extended to include several other conditions that must be satisfied to achieve a Multiple Liability Immunization.

In case of a parallel rate shift, these conditions assure an immunized rate of return.A minimum-risk immunized portfolio can be constructed using techniques such as linear programming if the interest rates shift in an arbitrary fashion.

Cash flow matching is easy to understand.There is a stream of liabilities that will be funded at certain times.A cash flow matching strategy uses cash flows from principal and coupon payments on bonds to match the liability amounts.This can be understood with an example.

The liability stream is shown in the table above.The last liability will be funded with a four-year $10,000 face-value bond with annual coupon payments of $1,000.The liability of $11,000 is satisfied by the principal and coupon payments.

Next, we look at the second to last liability, Liability 3 of $8,000, and fund it with a three-year $6,700 face-value bond with annual coupon payments of $300.Liability 2 of $9,000 can be funded with a two-year $7,000 face-value bond with annual coupon payments of $700.Liability 1 of $5,000 can be funded by investing in a one-year zero-coupon bond with a face value of $3,000.

There are several challenges in attempting to cash flow match a liability stream in the real world, and this is a simplified example.The bonds with face values and coupon payments might not be available.Excess funds should be reinvested at a conservative short-term rate if they are available before a liability is due.There is reinvestment risk in a cash flow matching strategy.Linear programming can be used to create a minimum reinvestment risk cash flow match by selecting a set of bonds.

In an ideal world in which one had access to all kinds of securities with a full range of face values, a cash flow matching strategy would create a perfect match between the flow of cash and liabilities.Cash flow matching is hard to achieve without a significant tradeoff in terms of higher cash investment and excess cash balances being reinvested at very conservative rates, as the ideal rarely exists in any real-world scenario.

In cash flow matching, cash flows must be available before a liability is due, whereas in multiple immunizations, liabilities are funded from cashflows derived from portfolio rebalancing on the basis of dollar durations.Cash flow matching is usually better than a multiple liability immunization strategy.

Cash flow matching may be favored for its simplicity in certain cases where the liability amounts and cash flows can be reasonably matched over the time horizon.In some cases, it is possible to combine the two strategies in combination matching, where the portfolio assets and liabilities are not just duration-matched for the complete time horizon but also cash-flow matched for initial few years.

H. Gifford Fong and Oldrich A. Vasicek.There is a risk minimizing strategy for portfolio immunizations.The Journal of Finance was published in 1984.

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