Liability Matching
What Is Liability Matching?
Liability matching is an investment strategy that matches future asset sales and income streams against the timing of expected future expenses. The strategy has become widely embraced among pension fund managers, who endeavor to limit a portfolio's liquidation risk by guaranteeing asset sales, interest, and dividend payments compare with expected payments to pension beneficiaries. This stands rather than less difficult strategies that endeavor to amplify return regardless of withdrawal timing.
How Liability Matching Works
Liability matching is filling in notoriety among sophisticated financial advisers and rich individual clients, who are utilizing different growth and withdrawal situations to guarantee that adequate cash will be accessible when required. The utilization of the Monte Carlo method of analysis, which utilizes a computer program to average the consequences of thousands of potential situations, has filled in its notoriety as an efficient device used to improve on a liability matching strategy.
For instance, retired people living off the income from their portfolios generally depend on stable and continuous payments to supplement social security payments. A matching strategy would include the strategic purchase of securities to pay out dividends and interest at normal spans. Preferably, a matching strategy would be in place a long time before retirement years start. A pension fund would utilize a comparative strategy to ensure its benefit obligations are met.
For a manufacturing enterprise, infrastructure designer or building contractor, a matching strategy would include arranging the payment schedule of debt financing of a project or investment with the cash flows from the investment. For instance, a toll road manufacturer would get project financing and start paying back the debt when the toll road opens to traffic and proceed with the consistently scheduled payments after some time.
Portfolio Immunization
A liability matching strategy for a fixed income portfolio pairs the durations of assets and liabilities in what is known as a immunization. In practice, precise matching is troublesome, however the goal is to lay out a portfolio in which the two parts of total return — price return and reinvestment return — precisely offset each other when interest rates shift. There is an inverse relationship between price risk and reinvestment risk, and assuming interest rates move, the portfolio will accomplish a similar fixed rate of return. At the end of the day, it is "inoculated" from interest rate developments. Cash flow matching is another strategy that will fund a flood of liabilities at indicated time stretches with cash flows from principal and coupon payments on fixed income instruments.
Immunization is viewed as a "semi active" risk relief strategy since it has the qualities of both active and passive strategies. By definition, pure immunization suggests that a portfolio is invested for a defined return for a specific period of time no matter what any outside impacts, for example, changes in interest rates.
The open door cost of utilizing the immunization strategy is possibly surrendering the upside capability of an active strategy for the assurance that the portfolio will accomplish the planned wanted return. As in the purchase and-hold strategy, by design, the instruments best appropriate for this strategy are high-grade bonds with remote prospects of default. As a matter of fact, the purest form of immunization is invest in a zero-coupon bond and match the maturity of the bond to the date on which the cash flow is expected to be required. This disposes of any variability of return, positive or negative, associated with the reinvestment of cash flows.
Features
- Pension funds progressively use liability matching to guarantee they won't run out of guaranteed funds for beneficiaries.
- Liability matching is an investment strategy that matches future asset sales and income streams against the timing of expected future expenses.
- This strategy varies from return maximization strategies that main gander at the assets side of the balance sheet and not the liabilities.
