Can someone here explain why the minimum immunization risk appraoch is likey to be better than cash flow matching?
it’s less expensive?
With cashflow you literally match the cashflows as best as possible, and you can use the reinvested income to offset future liabilities, with the former as long as PV matches and duration matches and in the case of a multiple liability case they bracket the CF’s your fine then you need to rebalance, but it’s not as iterative as the latter.
Also, due to the “precision” that is requried in cashflow matching, manager has to use a conservative reinvestment rate for cashflow immunization, therefore, it takes more $ to implement a cashflow matching immunization stragety.
Cash flow requires exact cash matches which needs more liquidity, hence constly. Immunization does not require exact matches as long as the asset maturity is concentrated around the liabilties.
This thread is really helpful, thanks. Question: Is cashflow matching a subset of immunization options, or is it qualitatively different? I tend to think of it as an immunization strategy with additional constraints to ensure that cash flows arrive at the right moments.
bchadwick Wrote: ------------------------------------------------------- > Question: Is cashflow matching a subset of > immunization options, or is it qualitatively > different? I tend to think of it as an > immunization strategy with additional constraints > to ensure that cash flows arrive at the right > moments. The whole topic of immunization revolves around valuation (mark-to-market) of your As and Ls – an earnings issue – it has nothing to do with cash flow planning (except coincidentally).
^^^ Right. As I understand it, it’s making sure that the duration of your assets matches the duration of your liabilities (and potentially matching convexity too), so that interest rate changes don’t suddenly create a gap (or larger gap) between assets and liabilities. The target rate of return is essentially the IRR (or YTM) required to make today’s assets generate income to meet all the liabilities at the times they are expected to be paid (and any planned future additions to asset base should be included in the relevant cash flows). The only extra trick is that instead of computing a strict IRR or YTM, you’re actually using the shape of the yield curve (or is it the forward rate curve?) to discount the value of future assets and liabilities, instead of assuming a single rate. Cash flow matching is more or less the same idea, except that you make sure that you have FI cash flows that arrive at exactly the right times to exactly cover your liabilities. You do this by purchasing bonds (usually zeros, but there are sometimes ways to do this with coupons too) that mature just when you need to make a payment. By doing this, you will almost guarantee that the durations and convexities match. However, because there are more constraints, it is likely that it is more expensive. If you are just immunized, but cash flows are not matched, then you need to sell off part of your portfolio when liabilities come due. If you have been earning the target rate of return, there should be enough in your portfolio to do this, but you are subject to reinvestment risk if the shape of the yield curve changes between now and then, because you will need to rebalance your portfolio to keep durations matched after you’ve sold off some assets to cover a liability. If you use cash flow matching, then there is nothing to worry about, because it’s just sitting back and waiting for things to mature. This stuff is fairly new to me. Is that about right?
Hmmm…I thought from the context of the material, cashflow matching is one of the option for immunization for multiple liabilities. You have classic immunization for single liability, mutiple immunization for mutiple liabilities, cashflow matching for multiple liabilities.
From the standpoint of the test I agree with ws on this. CF matching is grouped right in with the contingent immunization and everything else as “Immunization Strategies”. ws Wrote: ------------------------------------------------------- > Hmmm…I thought from the context of the material, > cashflow matching is one of the option for > immunization for multiple liabilities. > > You have classic immunization for single > liability, mutiple immunization for mutiple > liabilities, cashflow matching for multiple > liabilities.
What?? We care about other thing too, beside passing the exam in June??? 
bchadwick Wrote: ------------------------------------------------------- > ^^^ Right. As I understand it, it’s making sure > that the duration of your assets matches the > duration of your liabilities (and potentially > matching convexity too), so that interest rate > changes don’t suddenly create a gap (or larger > gap) between assets and liabilities. > > The target rate of return is essentially the IRR > (or YTM) required to make today’s assets generate > income to meet all the liabilities at the times > they are expected to be paid (and any planned > future additions to asset base should be included > in the relevant cash flows). > > The only extra trick is that instead of computing > a strict IRR or YTM, you’re actually using the > shape of the yield curve (or is it the forward > rate curve?) to discount the value of future > assets and liabilities, instead of assuming a > single rate. > > Cash flow matching is more or less the same idea, > except that you make sure that you have FI cash > flows that arrive at exactly the right times to > exactly cover your liabilities. You do this by > purchasing bonds (usually zeros, but there are > sometimes ways to do this with coupons too) that > mature just when you need to make a payment. By > doing this, you will almost guarantee that the > durations and convexities match. However, because > there are more constraints, it is likely that it > is more expensive. > > If you are just immunized, but cash flows are not > matched, then you need to sell off part of your > portfolio when liabilities come due. If you have > been earning the target rate of return, there > should be enough in your portfolio to do this, but > you are subject to reinvestment risk if the shape > of the yield curve changes between now and then, > because you will need to rebalance your portfolio > to keep durations matched after you’ve sold off > some assets to cover a liability. If you use cash > flow matching, then there is nothing to worry > about, because it’s just sitting back and waiting > for things to mature. > > This stuff is fairly new to me. Is that about > right? commenting on your statement “If you use cash flow matching, then there is nothing to worry about, because it’s just sitting back and waiting for things to mature.” Using cash flow matching, funds must be available when and may be before each liability is due because perfect matching is difficult. Thus we use a conservative rates of return assumption and moreover we will occasionaly have cash balances that needs to be reinvested for years in future. So cash flow matching is subject to reinvestment risk.
I am reviewing this for the 2nd time and still coming up with issues. With CF matching, the PM assumes reinvestment rates to be fairly low, if CF are available 2-3 months before the liability becomes due. So, yes there is reinvestment risk but it is fairly low as it will be only for a few months. Now if someone can explain to me, is if the PM is mimicking the index, how is mimicking the index similar to immunizing against a liability. Sch (Page 30 vol 3) says that index benchmark represents “min target value” of our portfolio?
I’m still a little hazy on this after re-reading it a few times. I get the whole single liability immunization where you match the P.V of the asset with the P.V of the liability as well as its duration. The reason you use duration is because of re-investment risk. If all one did was match the maturity dates of the asset and liability, they would still be susceptable to re-investment rate risk. What I find strange is that further into the material, they then start talking about matching the the maturity dates as if thats sufficient. Particularly, they reference this when discussing the barbell and bullet strategies. Does this relate to the CF Matching strategy? Where if you match the cash flows you receive to the maturity dates of the liabilities, that would obviously reduce re-investment rate risk? but the changes of doing so are unlikely as its difficult to perfectly time the cash flows? Also, if someone could just write a quick blurb on each of the immunization strategies and the main differences that would be great. Ran into a question where I thought multiple liability immunization strategy provided less risk than CF Matching due to re-investment rate risk but I was wrong, turns out CF Matching provides less risk of not achieving the desired liability amount but is more expensive. PJStyles
Good idea PJ…wish I was in the know well enough to write those blurbs…why do I have a feeling this is definitely showing up on the exam…pretty tricky and confusing little differences between all the strategies
OKay…someone please chime in on this. I want to put this area/topic to rest. Here’s my understanding as a whole. Classical Immunization (Minimum Risk Immunization Strategy) - Assumes parallel shifts in the yield curve. - Assumes PV of Liabilities do not change. - Assumes no impact or allowance of active management strategies The key to ensuring that a portfolio is immunized from parallel shifts, one must: a) Equate the bond portfolio’s PV to PV of the Liabilities b) Equate the duration of the portfolio to the duration of the liabilities c) The duration distribution of the portfolio must be “wider” than that of the liabilities Now the main issue/question I have is as it relates to “Re-Investment Rate Risk”. We are told early on that matching a portfolio’s maturity date to that of a liability is an insufficient means to immunizating a portfolio from yield curve shifts (parallel) because of re-investment rate risk. Hence, we must use duration. However, in looking specifically at the “Cash Flow Matching” approach. The goal is to have a portfolio whose cash flows ie: maturity values and coupons are at/near the maturity of the liability. I understand that by having a zero coupon bond at the maturity date of the liability there would be no re-investment rate risk. But if you’re holding a coupon bond of any sort, doesn’t this strategy directly contradict what was discussed earlier around how matching of maturity dates is insufficient to mitigate re-investment rate risk? I just need clarification on this one point. Also, just so I’m clear, the Mulitple Liability Appraoch is pretty much the same as the Single Liability Approach except now you have a portfolio of bonds to meet several liabilities in the future?? and both of these approaches are considered Minimum Immunization Risk Approaches - preferred over CF Matching because they are less expensive and result in less re-investment rate risk??? Thanks… PJStyles
There is also Horizon matching whcih is a combination of cash flow matching in the near term and immunization for the longer durations.
grexan Wrote: ------------------------------------------------------- > I am reviewing this for the 2nd time and still > coming up with issues. > > With CF matching, the PM assumes reinvestment > rates to be fairly low, if CF are available 2-3 > months before the liability becomes due. So, yes > there is reinvestment risk but it is fairly low as > it will be only for a few months. > > Now if someone can explain to me, is if the PM is > mimicking the index, how is mimicking the index > similar to immunizing against a liability. Sch > (Page 30 vol 3) says that index benchmark > represents “min target value” of our portfolio? Libility can be represented as pseudo (or real) portfolio of bonds. Benchmark is nothing more then just that.