Cash Flow Matching

The Ravensdale Foundation must pay a fixed grant of $500,000 at the end of each of the next eight years. Its adviser buys a set of high-grade zero coupon Treasury securities structured so that exactly $500,000 matures in each of those eight years. This approach is best described as:

1. A.A barbell strategy, because the maturities are concentrated at the short and long ends of the yield curve.Incorrect. A barbell deliberately avoids the middle maturities. These maturities are spread evenly across all eight years.
2. B.Cash flow matching, or a dedicated portfolio, which removes both price risk and reinvestment risk because each obligation is funded by a security maturing when it is due.Correct. Matching maturity amounts and dates to known liabilities is the definition of cash flow matching.
3. C.Immunization, which works by keeping the portfolio duration equal to the duration of the liabilities and rebalancing as rates change.Incorrect. That describes immunization, a different technique. No duration matching or rebalancing is being done here.
4. D.A bond ladder designed to average the reinvestment rate over the eight-year period.Incorrect. A ladder reinvests each maturity to smooth reinvestment rates. Here every maturity is spent on a grant, so nothing is reinvested.

Why: Cash flow matching, also called a dedicated portfolio, funds each known future obligation with a security that matures on the date the money is needed and in the amount needed. Because nothing must be sold before maturity, price risk is irrelevant, and because zero coupon bonds pay no interim interest, there is nothing to reinvest, so reinvestment risk is eliminated as well. The cost of that certainty is flexibility and, usually, a somewhat lower expected return than an actively managed alternative.

The Ridgemont Pension Trust owes a fixed lump sum in exactly seven years and wants that payment insulated from interest rate movements. Its consultant assembles a bond portfolio whose DURATION equals seven years. This technique - immunization - works because:

1. A.Duration matching removes the credit risk of the bonds held in the portfolio.Wrong. Immunization addresses interest rate risk only. Credit risk is managed by issuer selection and diversification.
2. B.Price risk and reinvestment risk move in opposite directions, and setting duration equal to the horizon makes them approximately offset.Correct. That offsetting relationship is the entire mechanism behind immunization.
3. C.A seven-year duration guarantees that every bond in the portfolio matures on the obligation date.Wrong. Duration is a weighted average sensitivity measure, not a maturity date. Matching actual maturities to the liability is cash flow matching, a different technique.
4. D.A portfolio's duration is fixed once established, so an immunized portfolio never needs rebalancing.Wrong. Duration drifts as time passes and as rates move, so an immunized portfolio must be rebalanced to stay matched.

Why: Immunization exploits the fact that a change in rates hurts a bondholder in one way while helping in another. If rates RISE, bond prices fall (price risk), but coupons are reinvested at the new higher rates (reinvestment benefit). If rates FALL, prices rise but coupons are reinvested at lower rates. Setting portfolio duration equal to the investment horizon makes those two effects approximately cancel, so the accumulated value at the horizon date is roughly insensitive to rate changes. Because duration drifts as time passes and rates move, an immunized portfolio must be rebalanced periodically to keep duration aligned with the shrinking horizon.