Evaluating Cash Flow Matching for Pension Payments

Very Hard Liability-driven Strategies Cash Flow Matching

A large pension fund is restructuring its fixed-income portfolio as part of a liability-driven investment strategy. The fund has forecasted annual pension benefit payments of $5 million over the next five years, and then a larger payment of $30 million due in year six. The fund manager is considering a cash flow matching strategy and evaluating two bond portfolios:

- Portfolio X: A series of zero-coupon bonds maturing in five years with a face value of $5 million, and a single zero-coupon bond maturing in year six with a face value of $30 million.

- Portfolio Y: A mix of coupon-bearing bonds that offer cash flows of $1 million annually for the first five years and a single coupon-bearing bond that matures in year six, providing a face value of $30 million.

The manager seeks to determine which portfolio best aligns with the liability stream of pension payments to ensure liquidity and avoid reinvestment risk.

Portfolio X is the better option as it perfectly matches the cash flow of the pension payments without any reinvestment risk.

Portfolio Y is preferable because it provides liquidity throughout the first five years through annual cash flows.

Both portfolios are equally effective since they cater to the total cash requirements over the six years.

Hint

Submitted1.0K

Correct972

% Correct95%