Cash Flow Matching in Fixed Income Portfolio Management

Consider a pension fund that has projected cash outflows of $5 million per year for the next 10 years, beginning in one year. The fund currently has a portfolio of fixed income securities with varying durations. The pension fund manager is considering a cash flow matching strategy to ensure that the fund can meet its liabilities.

Explain the principles of cash flow matching as a liability-driven investment strategy. Discuss how the manager could implement this strategy to align the cash flows from the fixed income portfolio with the anticipated liabilities of $5 million per year for the next 10 years. Include considerations of the types of securities that may be used and any potential challenges associated with this approach.