What is horizon matching and how does it blend cash flow matching with immunization?

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AcadiFi · Accepted Answer

Horizon matching (combination matching) uses cash flow matching for near-term liabilities and duration-matched immunization for long-term liabilities. Rationale: near-term cash flows are more certain and the cost of mismatching is high (you pay penalties on missed pension payments). Long-term liabilities can tolerate immunization because rates have more time to normalize and rebalancing opportunities exist. Structure. Split liabilities into two buckets. Bucket one: years 1-5, cash flow match with Treasuries/STRIPS. Cost: say $180M of the $380M PV. Bucket two: years 6-20, immunize with a duration-matched portfolio of intermediate and long-dated investment-grade corporates and agencies. Cost: $200M. Combined portfolio PV $380M meets total liability. Implementation. For bucket one, build the 5-year ladder backward from year 5 as in pure CFM. For bucket two, compute the modified duration and convexity of the remaining 6-20-year liability stream. Construct a bond portfolio matching that duration (say 11.2 years) with convexity at least as great as the liability. Rebalance bucket two annually or semiannually to maintain duration match as time passes and rates move. Advantages over pure CFM: lower cost by 2-4% because immunization is cheaper than exact matching. Advantages over pure immunization: near-term certainty eliminates liquidity and basis-risk concerns; you don't need to sell bonds at the worst time to meet next month's benefits. Risks: the transition point (year 5-to-6) is where you rely on rolling bucket one into bucket two eventually. Non-parallel rate shifts still affect bucket two; use key rate duration or multi-liability immunization to refine. Horizon matching is the standard for many closed DB plans and insurance reserves.

What is horizon matching and how does it blend cash flow matching with immunization?

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