Why is there greater risk in a multi-periodimmunization strategy than a cash flow matching strategy?
What will be an ideal response?
To understand the greater risk in a multi-period immunization strategy, we need to first understand the differences between the cash flow matching and multi-period immunization strategies. First, unlike the immunization approach, the cash flow matching approach has no duration requirements. Second, with immunization, rebalancing is required even if interest rates do not change. In contrast, no rebalancing is necessary for cash flow matching except to delete and replace any issue whose quality rating has declined below an acceptable level. Third, there is no risk that the liabilities will not be satisfied (barring any defaults) with a cash flow-matched portfolio. For a portfolio constructed using multi-period immunization, there is immunization risk due to reinvestment risk.
The differences just cited may seem to favor the use of cash flow matching. However, what we have ignored is the relative cost of the two strategies. Cash flow matching is more expensive because, typically, the matching of cash flows to liabilities is not perfect. This means that more funds than necessary must be set aside to match the liabilities. Optimization techniques used to design cash flow-matched portfolios assume that excess funds are reinvested at a conservative reinvestment rate. With multi-period immunization, all reinvestment returns are assumed to be locked in at a higher target rate of return.
In conclusion, portfolio managers face a trade-off in deciding between the two strategies: avoidance of the risk of not satisfying the liability stream under cash flow matching versus the lower cost attainable with multi-period immunization.
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