Schweser Exam 3PM page 189 has a phrase that says “a cash flow matching strategy would be free from immunization risk” and the phrase is said to be a correct statement.
The answer explains that “coupons are used to fund liabiities rather than being invested and therefore a cash flow matching strategy has no immunization risk.”
But isn’t immunization risk (which is a form of reinvestment risk) the risk of not being able to fund liabilities? If viewed like that, I think it is wrong to say cash flow matching has NO immunization risk. To me, the key difference between multiple imminization and CF matching is that one method relies on duration matching portfolio assets and liabilities and the other method relies on cash flows from coupons–but both have immunization risk.
Schweser Book 3 Page 40 even says “Because it is unlikely that the cash flows from a bond portfolio will exactly match the liabilities, reinvestment risk is inherent in cash flow matching.”
There will be no immunization risk assuming no defaults, because the liability stream is paid for entirely by coupon and principal.
With immunization strategies, the goal is to make sure the market value of the portfolio as a whole is equal to the liability which you wish to immunize at the immunization date, and the actual immunization is acheived by selling (or “re-balancing” as they say in the book). So you are selling bonds to meet the liability rather than relying on contracted principal, which is certain, absent default. Since you rely on market value at a certain time for standard immunization, there is price risk, and re-investment risk.
So the idea is that with multiple immunization, you have immunization risk because of nonparallel yield curve shifts (i.e. you are relying on duration to stay hedged), but with cash flow matching, you don’t care if interest rates change because everything has already been paid for and all cash via P and I is planned to be received on certain liabliity dates–you just need to ensure no defaults. Make sense?
Also, how would we make sense of the quote from the Schweser book–“Because it is unlikely that the cash flows from a bond portfolio will exactly match the liabilities, reinvestment risk is inherent in cash flow matching”.
Is the reinvestment risk they refer to different from immunization risk?
let the record show that i hate SS9
Ill do my best here…
Yes, the idea is you are relying on duration and selling assets or “reblancing” rather than having actual contractual cashflows (P & I) cover the liability using a recursive process.
Regarding your statement from Scweser, what they mean is it is hard to have your interest and principal streams be 100% matched to liabilities, because there just aren’t going to be enough issues that fall on random maturity dates like that. Because of this, you have to re-invest once your bond’s mature, and if rates have fallen alot and you did not plan on that in your strategy, you may not be able to cover the cost of the liability. This is why you have to assume very conservative rates of return when using cash flow matching, as the book mentions.
Regarding the precise diff between immunization risk and reinvestment risk, I cannot give you a perfect answer. I think the risk in immunization stems from both forms of interest rate risk (price, AND reinvestemnt) whereas the cash flow matching risk doesn’t have price risk, only reinvestment. These are my words though, and I do not recall them in the curriculum spelled out in this manner. The biggest diff to remember is that with immunization, you are relying on a value at a certain time, whereas CF matching, you are relying on principal and interst payments which should not be impacted by interest movements.