Multi Liability Immunization vs Cash Flow Matching

CFA Level III
#1

Hello,

Wondering if anyone can assist in clearing up a bit of confusion surrounding these two strategies. I feel like in the text with cash flow matching it implies that CF matching isn’t as effective as multi-liab matching; "…a minimum immunization risk approach should be as good as CF matching and will likely be better (Book 4 page 44). However in a EOC question at the end of that chapter (#13), the answer is that CF matching has less risk while CF matching is cheaper than mult liab. So I guess my question is; which method is ‘more effective’, which has less risk, and which is cheaper?

Thanks.

akf1

#2

My understanding is that CF matching is more expensive due to the requirement to use very conservative return assumptions since you are relying on interest and principal payments to fund liabilities using a recursive process. CF matching eliminates all yield curve risk, twists and shifts, so I would say it is more effective and the tradeoff is higher cost.

Please correct me if I am wrong.

#3

Schweser seems to agree with markCFAIL. CF matching is more expensive (due to assumptions, direct trading costs, monitoring costs) but it is more effective. When I get home I will try and find the page numbers.

#4

Yeah I know, I was under the impression that is the case too, but that section in the CFA books (assuming I’m understanding it correctly) is seeming to say that Mult liability matching is as effective or more effective than CF matching. I don’t have the passage here, but from what I recall it seems to say that CF matching is applied because it is intuitively easier to understand than mul. liab immunization.

#5

i would use the word “more effective” loosely. i wouldnt say cf matching is more effective. maybe in theory it is, since all CFs are accounted for.

but when u consider credit risk and the difficulty to have all the CF actually materialize, which is what the text emphasizes, its a less superior strategy than multiple imm

#6

Cash Flow Matching eliminates immunization risk (which includes only investing in US Treasuries and/or laying off your credit risk). It is also expensive to properly time the cash flows and periodically maintain large cash balances with conservative ROR assumptions.

Multiple liability immunization minimizes (but does not eliminate) immunization risk and requires less money to fund liabilities.

[My editorial] Perhaps cf matching is “technically inferior to immunization (p. 46)” because the cost of a properly cash flow matched portfolio is greater than even a poorly executed multiple liability immunization. (CFAI, vol 4, pg 45-46)

#7

WIth CF matching there is no immunization risk , but it is more expensive and has lower returns when compared to MLI

#8

CF matching is more expensive b/c you are investing at much more conservative (low) rates so you must front more money to get to your desired requirements

#9

WIth multiple liability immunization the goal is to ensure you have sufficient liquidity to meet liabilities as they come due.

To immunize multiple liabilities:

  1. Assets and liab must have same PV

  2. Assets and liab must have same durations

  3. Range of the distribution of durations of individual assets in the portfolio exceeds that of the liab.

Cash Flow Matching:

  1. Select bond with maturity date that equals last liab payment date

  2. Buy enough in par value to this bond so that its principal and final coupon payment fully fund the last liab

  3. Working backwards, choose another bond that fully funds the second to last liab payment and continue until all liab payments are covered

#10

I think i read some where if bonds under CF matching are Zero coupon bonds with maturity time & value equal to liabilities eliminate immunization risk. Otherwise CF matching is less risky than MLI but doesn’t completely eliminates immunization risk…is this not correct?