As a portfolio manager for a pension fund, you are tasked with implementing a liability-driven investment strategy. The primary objective is to ensure that assets will meet the projected future liabilities of the fund, which are forecasted to occur semi-annually over the next 10 years. To achieve this, you are considering a cash flow matching strategy using fixed income securities. Given the projected liabilities, you assess three separate fixed-income instruments available for purchase: Bond A: Maturity in 5 years, provides cash flows of $500,000 in semi-annual coupons, and $10 million at maturity. Bond B: Maturity in 10 years, provides cash flows of $1 million in semi-annual coupons, and $10 million at maturity. Bond C: Maturity in 6 years, provides cash flows of $750,000 in semi-annual coupons, and $7 million at maturity. Your forecasted liabilities require a total of $750,000 in 1 year, $1 million in 3 years, $1.5 million in 5 years, and $10 million at the end of 10 years. Based on the cash flows provided by these bonds, which bond should you select to best match the cash flows necessary to meet the projected liabilities?

Exam

CFA Level 3

Section

Difficulty

Fixed Income Portfolio Management

Cash Flow Matching for Liability-Driven Strategy

Very Hard Liability-driven Strategies Cash Flow Matching

As a portfolio manager for a pension fund, you are tasked with implementing a liability-driven investment strategy. The primary objective is to ensure that assets will meet the projected future liabilities of the fund, which are forecasted to occur semi-annually over the next 10 years. To achieve this, you are considering a cash flow matching strategy using fixed income securities.

Given the projected liabilities, you assess three separate fixed-income instruments available for purchase:

Bond A: Maturity in 5 years, provides cash flows of $500,000 in semi-annual coupons, and $10 million at maturity.
Bond B: Maturity in 10 years, provides cash flows of $1 million in semi-annual coupons, and $10 million at maturity.
Bond C: Maturity in 6 years, provides cash flows of $750,000 in semi-annual coupons, and $7 million at maturity.

Your forecasted liabilities require a total of $750,000 in 1 year, $1 million in 3 years, $1.5 million in 5 years, and $10 million at the end of 10 years. Based on the cash flows provided by these bonds, which bond should you select to best match the cash flows necessary to meet the projected liabilities?

Bond A

Bond B

Bond C

Hint

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