Question

In: Finance

Which of the following statements is true? 1.Cash flow matching require rebalancing 2.None of the above...

Which of the following statements is true?

1.Cash flow matching require rebalancing

2.None of the above

3.Firms dislike convexity in their liabilities

4. Immunization does not require rebalancing

Solutions

Expert Solution

Portfolio Immunization involves the matching of the duration of the future liabilities with the duration of the assets in the portfolio. Thus, the present value of the liabilities should be equal to the present value of the liabilities. The duration of the assets in the portfolio must exceed the duration of the liabilities in the portfolio. In Portfolio immunization, the liabilities are paid from the cash flows that are available after portfolio rebalancing based on dollar durations. This has the effect of reducing the effect of fluctuations in interest rate and therefore, this is a risk mitigation strategy. In this strategy, the portfolio has to be rebalanced over the funding period.

Cash Flow Matching the intention to manage cash flows in such a way that cash is available when the liabilities become payable and due. Any surplus over a given period is used to fund future liabilities and is less risky as compared to Immunization because the volatility of interest rates does not impact greatly in Cash Flow Matching as compared to Immunization because cash flows are calculated before-hand and provisions have been made. A certain level of exactness and precision are needed to match cash flows. However, unlike in Immunization, in case of a duration mismatch, there is no need to rebalance in the Cash Flow Matching model.

Convexity of liabilities affects the yield of the portfolio. In case of liabilities, in a given duration, when yield rises, there is less fall in the value of the liabilities and there will be increase in the value of the liabilities when the yield rises. Liabilities are essentially convex. Convexity of liabilities means the firm is making the right decisions when the interest rates fall and is less wrong when the interest rates rise.

Answer 2


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