Fixed Income PM (1) EOC first item set: Cécile Perreaux Scenario

CFA Level III
#1

Extract of question:

Daasvand asks Perreaux to analyze immunization approaches to liability-based mandates for a meeting with Villash Foundation. Villash Foundation is a tax-exempt client. Prior to the meeting, Perreaux identifies what she considers to be two key features of a cash flow–matching approach.

Feature 1: It requires no yield curve assumptions.

Feature 2: Cash flows come from coupons and liquidating bond portfolio positions.

Q. Is Perreaux correct with respect to key features of cash flow matching?

A. Yes.
B. No, only Feature 1 is correct.
C. No, only Feature 2 is correct.

B is correct. Cash flow matching has no yield curve or interest rate assumptions. With this immunization approach, cash flows come from coupon and principal repayments that are expected to match and offset liability cash flows. Because bond cash inflows are scheduled to coincide with liability cash payouts, there is no need for reinvestment of cash flows. Thus, cash flow matching is not affected by interest rate movements. Cash flows coming from coupons and liquidating bond portfolio positions is a key feature of a duration-matching approach.

Can anybody explain to me why the bolded part is a key feature of a duration-matching approach? Isn’t that a key feature of cashflow matching approach?

I couldn’t find such explanation in the CFAI text. This is bugging me.

#2

No.

In cash flow matching, the maturity of the bonds matches the dates of the payments, so you don’t need to sell (i.e., liquidate) the bonds.

In duration matching, you often have bonds with longer maturities than the liabilities, requiring that you sell (i.e., liquidate) the bonds to make the liability payments, and, therefore, exposing you to price risk.

2 Likes
#3

Oh I see. Now I get it. I interpreted “liquidating” as “redemption” somehow.

Think I more sleep.

Thanks… again. I owe you a beer.

#4

My pleasure.