Matching Strategy

What Is a Matching Strategy?

A matching strategy (or cash flow matching) is the identification and accumulation of investments with payouts that will harmonize with an individual or company's liabilities. It is one type of dedication strategy, by which anticipated returns on an investment portfolio are matched to cover those estimated future liabilities.

Under a matching strategy, every investment is picked in light of the financial backer's risk profile and cash flow requirements. The payout could comprise of dividends, coupon payments, or principal repayment.

Grasping Matching Strategies

A matching strategy for a fixed-income portfolio pairs the durations of assets and liabilities in what is known as immunization. In practice, definite matching is troublesome, however the goal is to lay out a portfolio in which the two components of total return — price return and reinvestment return — precisely offset each other when interest rates shift.

To accomplish this, a cash flow matching strategy utilizes future cash flows from principal and coupon payments on different bonds or different securities that are picked to such an extent that the total cash flows will precisely match the liability sums.

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. All in all, it is "vaccinated" from interest rate developments. Cash flow matching is another strategy that will fund a surge of liabilities at determined time stretches with cash flows from principal and coupon payments on fixed income instruments.

Illustration of Cash Flow Matching

The table above shows a liability stream expected north of four years. To fund these future liabilities with cash flow matching, we start with funding the last liability with a four-year $10,000 face-value bond with annual coupon payments of $1,000 (Row C4 in the table). The principal and coupon payments together fulfill the liability of $11,000 at year four.

Next, we take a gander at the second-to-last liability, Liability 3 of $8,000, and fund it with a three-year $6,700 face-value bond with annual coupon payments of $300. Next, we take a gander at Liability 2 of $9,000 and fund it with a two-year $7,000 face-value bond with annual coupon payments of $700. At long last, by investing in a one-year zero-coupon bond with a face value of $3,000, we can fund Liability 1 of $5,000.

This, of course, is a simplified model, and there are several moves in endeavoring to cash flow match a liability stream in reality. In the first place, the bonds with the required face values and coupon payments probably won't be accessible. Second, there may be excess funds accessible before a liability is due, and these excess funds must be reinvested at a conservative short-term rate. This prompts some reinvestment risk in a cash flow matching strategy.

Once more, linear programming procedures might be utilized to choose a set of bonds in a given setting to make a base reinvestment risk cash flow match.

Different Uses of a Matching Strategy

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 standard stretches. In a perfect world, a matching strategy would be in place a long time before retirement years start. A pension fund would utilize a comparable 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 developer would get project financing and start paying back the debt when the toll road opens to traffic and proceed with the consistently scheduled payments over the long run.

Features

• The goal is to get fixed-income securities whose payments line up with liability outflows.
• Matching strategies depend on the availability of securities with specific principal sums, coupon payments, and maturities to proficiently work.
• Matching is a cash flow immunization strategy used to defend the funding of future liabilities when due.