9.40 Dedication Mechanics: “Cash Flow Matching” The Basic Idea
The following is a simple, but unrealistic example of Cash Flow Matching (CFM). Liberties, as you will see, have been taken with the calculations of the principal and coupon cash flows. Still, the rudimentary notion of Cash Flow Matching will come across. CFM will then be presented more realistically using Zero-coupon bonds followed by a still more complex example using positive coupon bonds.
| Expected Liability |
|
$20,000 |
$36,000 |
$32,000 |
$44,000 |
| Principal Cash Flow |
|
12,000 |
28,000 |
$26,800 |
40,000 |
| Coupon Payments |
| 4-year Bond |
4,000 |
4,000 |
4,000 |
4,000 |
| 3-year Bond |
1,200 |
1,200 |
1,200 |
0 |
| 2-year Bond |
2,800 |
2,800 |
0 |
0 |
| Total Cash Flow |
|
20,000 |
36,000 |
32,000 |
44,000 |
Cash Flow Matching is implemented by using a reverse algorithm. First, we state the expected future liabilities. Next, we start with the fourth year’s inflows. To match the fourth year’s liability, we invest in a bond that will mature in four years with a face value of $40,000. This bond will also produce yearly cash flows of $4,000. One can readily see that the total, or additive cash flows in the fourth year will equal the expected liability of $44,000.
Next, the investor chooses a three-year bond with a principal value of $26,800 and annual coupon payments of $1,200. Then, s/he chooses a two-year bond with principal payments of $28,000 and coupon payments of $2,800. In each of the noted cases, the cash inflows add up to the expected liability.
While the concept of CFM is quite simple, it may be difficult to implement as there may not be bonds which are available whose characteristics meet the needs of the strategy. The cash flow produced may be less than or greater than the amounts required at any point over the investment period. It is quite apparent that liberties were taken with the data in this illustration.
