Cash Flow Matching Strategies

Interest rate immunization

Interest rate immunization is a financial strategy used to manage the risk associated with changes in interest rates. It is applicable to both single and multiple liabilities, assuming that the cash flows are of Type I, where the scheduled amounts and payment dates are known. Two primary approaches are used to manage these liabilities: Cash Flow Matching and Duration Matching.

Cash Flow Matching

Cash flow matching is used to mitigate the interest rate risk arising from multiple liabilities. This strategy involves constructing a dedicated portfolio of high-quality fixed-income bonds, such as government or corporate bonds, that aligns with the amount and timing of the scheduled cash outflows. For instance, if a company has a liability of $1 million due in five years, it would purchase bonds that will mature in five years, generating $1 million. This strategy can improve the company’s credit rating as it demonstrates the company’s ability to retire its debt liabilities.

Accounting Defeasance

Accounting defeasance, also known as in-substance defeasance, is a method of extinguishing a debt obligation by setting aside sufficient high-quality securities, such as US Treasury notes, to repay the liability. This process could lead to large cash holdings between payment dates and, therefore, cash flow reinvestment risk, especially if yields on high-quality, short-term investments are low.

Cash-in-Advance Constraint

• The cash-in-advance constraint requires that sufficient funds must be available on or before each liability payment date. Securities cannot be sold to meet obligations at the time of payment.
• Traditional bonds, with fixed coupon rates and principal repayment at maturity, are not ideal when liabilities resemble a level payment annuity (e.g., consistent periodic payments).
• This mismatch can result in:
  • Large cash holdings accumulating between liability payment dates.
  • Increased cash flow reinvestment risk, particularly when yields on high-quality, short-term investments are low or negative.
• The primary challenge lies in aligning cash inflows from investments with the timing and size of liability outflows, minimizing inefficiencies and managing reinvestment risk effectively.

Duration Matching

Duration matching is another approach that extends the ideas of cash flow matching to a portfolio of debt liabilities. This approach involves aligning the duration of assets in the portfolio with the duration of the liabilities. However, this approach is not discussed in detail in these notes.

Practice Questions

Question 1: A pension fund is seeking to manage its interest rate risk associated with funding future liabilities. The fund is considering duration matching as a strategy. What does duration matching involve, and why might it be preferred over cash flow matching for managing multiple liabilities?

1. Duration matching involves aligning the duration of the fund’s assets with the duration of its liabilities. It might be preferred over cash flow matching because it is more flexible and can manage liabilities without requiring exact cash flow alignment.
2. Duration matching involves constructing a portfolio of high-quality bonds that mature at the same time as the liabilities. It might be preferred over cash flow matching because it minimizes the risk of reinvestment.
3. Duration matching involves diversifying the fund’s investments across multiple asset classes to reduce risk. It might be preferred over cash flow matching because it provides higher expected returns.

Answer: Choice A is correct.

Duration matching involves aligning the duration of the portfolio’s assets with the duration of the liabilities. This strategy is often preferred over cash flow matching because it provides flexibility in managing multiple liabilities. Unlike cash flow matching, which requires the precise alignment of cash inflows and outflows, duration matching ensures that the portfolio’s sensitivity to interest rate changes mirrors that of the liabilities. This allows for more efficient management of interest rate risk without the need for exact cash flow matching, making it particularly effective for portfolios with complex or irregular liability structures.

Choice B is incorrect. While duration matching considers the timing of liabilities, it does not require bonds to mature exactly when the liabilities come due. This is a characteristic of cash flow matching, not duration matching. Additionally, duration matching does not inherently minimize reinvestment risk, as it focuses on interest rate sensitivity rather than cash flow timing.

Choice C is incorrect. Diversification across multiple asset classes is a general investment principle but is not specific to duration matching. Duration matching focuses on aligning the duration of assets and liabilities rather than seeking higher returns through diversification. Its primary goal is to manage interest rate risk, not to maximize returns.

Glossary

• Cash Flow Matching: A strategy used to mitigate interest rate risk by aligning the amount and timing of cash inflows from a portfolio with the amount and timing of an entity’s expected cash outflows.
• Accounting Defeasance: A method of extinguishing a debt obligation by setting aside sufficient high-quality securities to repay the liability.
• Duration Matching: A strategy that involves aligning the duration of assets in the portfolio with the duration of the liabilities.

LOS 2(h): describe the strategy of cash flow matching