Schwser VOL II Exam3 Q19.6 As an alternative to multiple liability immunization, the Cicatrix pension fund could employ a cash flow matching strategy. A cash flow matching strategy would be free from immunization risk and typically would require less capital to fund the pension liabilities. Are the comments correct regarding immunization riska nd capital requirements for a cash flow matching strategy? Please explain
If Cash flow matching is done exactly (which is hard to do) that means that the cash flows from the investment perfectly match up with the liabilities due. With this there is no reinvestment rate risk which means no immunization risk and no cash flow match risk. I can’t comment to intelligently on the cash part of it but I think with an immunization strategy there is a much heftier portfolio investment to get the desired immunization.
^ I was looking over CFAI stuff and Cash Flow matching is more expensive. Not sure but may be because it uses a more conservative rate of return assumption? Anyone with insights on that?
I read the same thing as Gmofden. confused
anyone can clarify this? thanks
First comment is wrong ,second one is right (due to the word typically on the question) Ideally, (or maybe the word is theoretically), cash flow matching would be designed to fully and perfectly matched the multiple liabilities. However, in reality, it is practically unachievable. So the manager will go out and buy a bond that will mature in sync with the last liability, there you go, immunization achieved for the last leg. However, for the next of last liability (second last), the manager has to go out and buy a bond net of that liability less the coupon payment receive from the initial bond to have a cash flow match. After buying that bond, if interest rates declined, the coupon payment that was unlikely received at the exact time of the next to last liability will be reinvested at lower rates. But that’s too bad because the manager already bought the bond net of the expecting coupon payment with the assumption of reinvestment of cash. RIGHT THERE, REINVESTMENT RISK! Which is part of immunization risk. Now the manager has a mismatch. On the capital requirements, it would require the same capital than the liability itself because you’re buying the present value of the liability through bonds and the respective coupons (but more funds than an immunization). However, removing Time Value, you would be investing less than the absolute amount of the expected pension payout…but from a sound financial perspective, it is the same value in present value terms… hat’s the TYPICAL scenario.
I agree with Leo_land on the reinvestment risk. ( But the schwser answer says otherwise. The answer says BOTH arguments are CORRECT) On the capital requirement side, shouldn’t both immunization and cash flow strategies require the same amount of capital=pv(liability). Although cash flow needs better time match, whereas immunization only requires the average amount of capital to be equal, not the distribution patter? Why one is higher in term of capital requirement?
The comment regarding immunization risk is correct. By cash flow matching, you effectively use zero coupon bonds to match the cash flow liabilities, and therefore removing all the reinvestment risk. The comment about less capital to fund the cash flow matching is not correct. This is because you will have to purchase a zero coupon bond for exactly the amount and date of the cash flow liability, this can be expensive because you have to buy from a limited pool of bonds regardless of liquidity…