Asymmetric cash matching, Financial Management

Assignment Help:

When a set of predetermined liabilities are given, the investor must construct a non-callable bond portfolio of homogeneous ratings by considering certain characteristics such as follows:

  • The bond portfolio cash flow must occur in such a way that at any time a liability matures, the cumulative bond portfolio cash-flow is comparatively larger than the cumulative cash-flow of liabilities.

  • The amount and maturity of both asset as well as liability cash flows must match to the possible extent.

With the first condition, the investor is assured that every liability will be funded in the future. The second condition will make sure that the exposure to term structure risk factors of assets and liabilities will match to the possible extent, thus limiting risk-taking on the net value of both assets as well as liabilities. However, this technique does not entail the risk of not being able to fund the liability system. This method can be implemented using minimal information on cash flows.

Let us assume that we have pricing information on bonds and we can adopt an operational way of implementing the second rule by minimizing the value of bond portfolio. Further, let us assume that a single liability of 100 will mature in 5 years. Let us also consider two zero-coupon bonds maturing in 4.5 and 4.9 years respectively. Now, the investor must invest  either Rs.65.12 in the first discount bond or 62.69 in the second one in order to fund his liability. The significant point to be noted here is that if the investor is choosing the cheapest portfolio, he will be choosing the best cash-flow match also and thus the least risk. However, this minimization of the value of the bond portfolio can be applied only on bonds of same quality. Otherwise, it will pick up only bonds of lesser quality.

By using this procedure, the investor will have enough cash in advance to fund each liability. He may hold cash in certain time periods, such as the period between the time he receives it and the time he funds the liability. Thus, there is immense possibility of reinvesting this cash for a short period of time.

By considering the reinvestment possibility which is based on an assumption for the reinvestment rate for the cash, the procedure for minimizing the value of the bond can be refined further. At the same time, the investor also depends on the return he receives from the cash to fund the liabilities. Reinvestment risk can arise if the investor is unable to fully fund the liabilities when he actually reinvests at a lesser rate compared to assumed rate.

Finally, we can say that the minimization technique can be applied periodically to take advantage of the emergence of term structure in order to construct an even cheaper bond portfolio. To solve this problem, optimization methods such as linear programming can be used.


Related Discussions:- Asymmetric cash matching

Sources of return, When an investor invests in fixed income sec...

When an investor invests in fixed income securities, he receives returns from one or more of the following sources: Coupon Interest payment.

Historical weights, Can some one tell me the defination of Historical weigh...

Can some one tell me the defination of Historical weights and how we calculate the historical weight?? And given the diffrence between Historical weight Vs Marginal weights??

What is the usual pattern of cash flows, What is the usual pattern of cash ...

What is the usual pattern of cash flows for a share of preferred stock? How does the market determine the value of a share of preferred stock, given these promised cash flows?

Business plan, Identify and describe three types of start ups firms. Give a...

Identify and describe three types of start ups firms. Give an example of one you have dealt with. What is a business plan, what are its major components, and why is it important

Dry up of liquidity and increased correlation, Hedge funds are short two ty...

Hedge funds are short two types of funding options. Describe in detail what these options are. Describe why these options become more valuable during a financial crisis. During

Explain about the working capital management, Explain about the Working Cap...

Explain about the Working Capital Management Working Capital Management is concerned with the management of current assets. It's a significant and integral part of financial m

Determine the working capital cycle, Working capital cycle (operating/tradi...

Working capital cycle (operating/trading/cash cycle) It is the time between paying for goods supplied and final receipt of cash from their sale. It is desirable to keep cycle a

Calculate the present value and determine the npv, Assume today is 3 Decemb...

Assume today is 3 December 2009. Helen is 30 years old and has a Bachelor of Business. She is currently employed as a personal banker for ANZ banking group in Sydney and earns $380

Optimal capital structure, (a) The calculation of the Weighted Average Cost...

(a) The calculation of the Weighted Average Cost of Capital (WACC) is theoretically easy but practically complex. Discuss. (b) Two-fifths of the total market value of Jefferson

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd