Matching Strategy What it is How it Works Example

Matching Strategy What it is How it Works Example

Matching Strategy: What it is, How it Works, Example

What Is a Matching Strategy?

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

Under a matching strategy, investments are chosen based on the investor’s risk profile and cash flow requirements. The payout might consist of dividends, coupon payments, or principal repayment.

Key Takeaways

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

Understanding Matching Strategies

A matching strategy for a fixed-income portfolio pairs the durations of assets and liabilities in immunization. In practice, exact matching is difficult, but the goal is to establish a portfolio in which the two components of total return—price return and reinvestment return—exactly offset each other when interest rates shift.

To achieve this, a cash flow matching strategy makes use of future cash flows from principal and coupon payments on various bonds or other securities that are chosen to exactly match the liability amounts.

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There is an inverse relationship between price risk and reinvestment risk, and if interest rates move, the portfolio will achieve the same fixed rate of return. In other words, it is "immunized" from interest rate movements. Cash flow matching is another strategy that will fund a stream of liabilities at specified time intervals with cash flows from principal and coupon payments on fixed income instruments.

Example of Cash Flow Matching

The table above shows a liability stream expected over 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 satisfy the liability of $11,000 at year four.

Next, we look 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 look at Liability 2 of $9,000 and fund it with a two-year $7,000 face-value bond with annual coupon payments of $700. Finally, 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 is a simplified example, and there are several challenges in attempting to cash flow match a liability stream in the real world. First, the bonds with the required face values and coupon payments might not be available. Second, there might be excess funds available before a liability is due, and these excess funds must be reinvested at a conservative short-term rate, resulting in some reinvestment risk in a cash flow matching strategy.

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Linear programming techniques may be used to select a set of bonds in a given context to create a minimum reinvestment risk cash flow match.

Other Uses of a Matching Strategy

Retirees living off the income from their portfolios generally rely on stable and continuous payments to supplement Social Security payments. A matching strategy would involve the strategic purchase of securities to pay out dividends and interest at regular intervals. Ideally, a matching strategy would be in place well before retirement years commence. A pension fund would employ a similar strategy to ensure its benefit obligations are met.

For a manufacturing enterprise, infrastructure developer, or building contractor, a matching strategy would involve lining up the payment schedule of debt financing of a project or investment with the cash flows from the investment. For example, a toll road builder would obtain project financing and begin paying back the debt when the toll road opens to traffic and continue the regularly scheduled payments over time.

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