What is the matching strategy?
The matching strategy, which others prefer to call cash flow matching, identifies and accumulates investments with payouts that will match an entity’s liabilities. Thus, it has such a name. It is a dedication strategy where the investment portfolio’s anticipated returns are matched to cover the estimated future liabilities.
The investments are chosen during a matching strategy based on how much risk an investor can tolerate and whether he can meet the cash flow requirements. In terms of payouts, we may have dividends, coupon payments, and/or principal repayment.
What does immunization mean?
Immunization is pairing the duration of assets and liabilities when using the matching strategy for fixed-income portfolios. We say this, but accurate matching is challenging. So, the aim is to at least have a portfolio with two components of total return that exactly offsets each other during an interest rate shift. The two components of return that we are talking about here are the price and investment return. How can we make this possible? The matching strategy uses future cash flows from the principal and coupon payments on different bonds or other securities. These are chosen so that the total cash flows will accurately match the liability amounts.
The price and investment risk have an inverse relationship. If the interest rates move, the portfolio will have a similar fixed rate of return. Hence, we can say that it is immunized from the movements of the interest rate. The matching strategy funds liabilities at given time interval cash flows from both the coupon payments and principal on fixed income instruments.
What can go wrong?
Cash flow matching a liability stream is not an easy task. There are challenges that you may encounter along the way. First, the bonds with coupon payments and required face values might be unavailable. Next, extra funds might be available before the due date of liability. So, they can be reinvested at a short-term rate. Sometimes, this can end up with reinvestment risks if used with a matching strategy. However, we can always use linear programming techniques to choose bonds in a given context and create a minimal investment risk during a cash flow match.
What else can a matching strategy do?
Retirees mostly do not or cannot work anymore. So, they only depend on the income they get from their portfolios. On the other hand, these portfolios rely on continuous payments to make social security payments. But what does the matching strategy have to do with this? Before retiring, you can place a matching strategy. Pension funds would make the same strategy to ensure the benefit obligations are met.
Did you know? The matching strategy is also applicable to other fields such as the manufacturing enterprise, infrastructure developer, and building contractor. It involves payment schedule line ups of a project or investment debt financing with the investment’s cash flows. For example, a building contractor can have project financing and start paying back once the building opens and continue to make regular payments in the long run.