This makes intuitive sense , yet I cannot fully agree with it.
My impression of cash flow matching was that you select bonds with specific maturities that pay off just when each strip of liability comes due.
Is this because you may not get exact maturity instruments , so you might have to re-invest interim cash flows at a possible reduced coupon ?
It depends. If you are using pure zero coupon bonds, then reinvestment risk is 0
I think I remember reading that even when you use zeros , you may not get the exact maturity desired . Lets say you have a maturity of liability set to 3 years , but available instruments are 2 years . So you have to go for 2 , then roll into a different bond upon maturity , and are subject to re-investment risk. In other words you may not be able to match the cash flows exactly
^ Correct, unless you can perfectly match up the cash flows, you will be exposed to reinvestment risk if the closest bond matures before the liability date. If the closest bond matures after the liability date, you will be exposed to interest rate risk.
Yea I was referring to perfect CF matching
In CF matching you make conservative assumption about the reinvestment rate
cash flow matching has a HUGE amount of reinvstment risk because you are relying on the reinvestments of the coupons to continue to match your liabilities. that is precisely why conservative reinvestment rates are assumed.