What is cash-flow matching (dedication) and when is it preferred over duration matching?

Question

AcadiFi · Accepted Answer

Cash-flow matching (dedication) is a strategy where bond coupons and principal are scheduled to exactly match liability cash flows as they come due. No rebalancing, no reinvestment risk. Mechanics: Step 1: LIST LIABILITY CASH FLOWS BY DATE. Step 2: PICK BONDS whose coupon+principal cash flows match each liability date. Step 3: HOLD TO MATURITY — no trading needed. Example: Riverstone Pension has liabilities: - Year 1: $2M - Year 2: $2.1M - Year 3: $2.2M - Year 4: $2.3M - Year 5: $2.4M Buy a 5-year bond with 5% coupon, $48M face. Coupons: $2.4M/year for 5 years. Principal: $48M at year 5. That overshoots year 5 and doesn't quite match years 1-4. Adjust: buy a ladder of 1y, 2y, 3y, 4y, 5y zeros (or near-zeros) with face values equal to each year's liability. ```mermaid flowchart LR A[1yr Zero
2M] --> X[Y1 Pay] B[2yr Zero
2.1M] --> Y[Y2 Pay] C[3yr Zero
2.2M] --> Z[Y3 Pay] D[4yr Zero
2.3M] --> W[Y4 Pay] E[5yr Zero
2.4M] --> V[Y5 Pay] ``` When preferred over duration matching: 1. HIGH-CONFIDENCE LIABILITIES: Pension benefits, annuity payouts, legal settlements with fixed schedules. 2. REGULATORY / ACCOUNTING: Some jurisdictions allow reduced capital charges or 'funded status' recognition for dedicated portfolios. 3. LOW RATES / HIGH UNCERTAINTY: When rebalancing risk is high, dedication removes it. Disadvantages: 1. COST: Cash-flow matching is typically 5-15% more expensive (in PV terms) than duration matching because you lose flexibility to optimize yield. 2. LIQUIDITY: Requires finding bonds that mature at the right dates — hard for distant dates. 3. CREDIT CONCENTRATION: May force holding lower-credit bonds at specific maturities. Hybrid 'combination matching' uses cash-flow matching for near liabilities (0-5y) and duration matching for later ones.

What is cash-flow matching (dedication) and when is it preferred over duration matching?

Master Level III with our CFA Course

Related Questions

Practice Questions