CFA Level 3 | Fixed Income: Cash Flow Matching

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CFA Level 3
Topic: Fixed Income Portfolio Management
Reading: Liability-Driven and Index-Based Strategies
The cash flow matching strategy is a classic immunization strategy for eliminating interest rate risk by matching a dedicated portfolio of fixed income securities (preferably high-quality) to match the multiple liabilities that fall due.
The first example in the video illustrates how the calculation of the required par value of bond is done. We start from the final cash flow and work slowly to the front.
In the second example, I impose a constraint where there is a minimum denomination for the government bonds purchased. Always do a check on the total cash flow to make sure your figures are not too far off from the intended outflows.
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[@jakelunness680]

Great video, thank you!

[@ricoronaldo7914]

Excellent video. Thank you Sir!

[@FabianMoa]

You're welcome, Rico!

[@simfinso858]

Very nice video

[@muhammadsaad4750]

Many thanks Fabian. Highly appreciated. However can you provide some intuitive insight on the CASH IN ADVANCE Constraint thing mentioned in the CFA curriculum? Would be much helpful.

[@ivyg9827]

THANK YOU! Amazing videos!

[@FabianMoa]

No problem, Ivy! I saw that you asked about rounding to nearest 10k. Hope it is okay now.

[@ivyg9827]

@@FabianMoa Thank you for checking. 10:03: I thought the investment would be $3,580,000 instead of $3,570,000

[@FabianMoa]

Is it okay for you now? If it is 3,575,000 and above then you will round to 3,580,000. Anything below 3,575,000, round to 3,570,000

[@ivyg9827]

@@FabianMoa Thanks;)

[@seeknsend]

Great videos. Major help! Was hoping to understand why you don't discount the ending value by the time factor?

[@FabianMoa]

We don't have to discount the ending value as the total cash inflow (principal + coupon) offsets the cash outflow (i.e. net cashflow is zero)

[@johnchung120]

Quick question, if let's say all 3 par values get rounded down, leading to shortfall in covering the liabilities - is there any optimal (CFA) way to decide which bond we should buy more to cover the shortfall? This may not show up on CFA (hopefully)...but I am curious ..Thanks Fabian in advance!

[@FabianMoa]

No optimal way really. Some may prefer to hold a buffer in money market and continue to re-invest until the liability due dates to cover any shortfall. That strategy is subject to fluctuations in reinvestment rates. Some may buy a longer-term bond, but that strategy is exposed to price risk. So, it depends on the mandate.

[@ankushmishra5999]

Hello Sir, Thank you for the video. It was really helpful. I have one complex question on the same topic. Would you be able to help to make me understand the question and also help to solve with some explanation about the question and solution if possible? If so, would you let me know where i can share the question? Thank you in advance sir.

[@harrisywh]

great video, thank you. But why par value of 2/3 yrs bonds only discounted by 1 year? should they be discounted back to T0 to 2019?

[@FabianMoa]

I'm not discounting them. I divided the Liability cashflow by (1 + Coupon rate) to get the required par value of the bond

[@harrisywh]

@@FabianMoa thank you for that! would you mind I ask another quick question, for questions to justify why 1 out of 3 statements are correct, do we need to (or do we get points for) explain why the other 2 statements are wrong? especially, sometimes it is hard to "justify" by stating the same fact the correct statement already pointed out

[@FabianMoa]

You can give short reasons why the other two statements are incorrect. But your main content is still to explain why the statement that you select as correct, is correct. An example is a statement that says "Cash flow matching strategy eliminates interest rate risk". This statement is correct and you will go on justify that "cash flow matching strategy eliminates interest rate risk because it matches the cash inflows from the bonds to the cash outflows of the liabilities, thereby removing any risk of a shortfall".

[@harrisywh]

thanks Fabian again highly appreciated. very useful indeed!