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

Decentralization, Decentralization This is a company power structure i...

Decentralization This is a company power structure in which authority and decision-making responsibility are diffused throughout various stages of an organization. Decentraliz

What are the objectives of financial management, What are the Objectives of...

What are the Objectives of Financial Management To make wise decisions a clear understanding of the objectives that are sought to be achieved in compulsory. Objectives provide

Define the problems into capital budgeting analysis, What problems can take...

What problems can take place into the capital budgeting analysis if project debt is evaluated in place of the borrowing capacity created by the project? If project debt is grea

Benefit and drawback of maintaining many manufacturing sites, Discuss the b...

Discuss the benefits and drawbacks of maintaining multiple manufacturing sites like a hedge against exchange rate exposure. Answer:  To set up multiple manufacturing sites can

Advantage of profitability index method, Q. Advantage of Profitability Inde...

Q. Advantage of Profitability Index method? Advantage of PI method:- (i) Similar to the other DCF techniques the PI method as well takes into account the time value of money

Explain the term- market penetration, Explain the term- Market penetration ...

Explain the term- Market penetration A strategy which pursues to increase sales of existing services or products to the same market. Price reduction strategies Aggre

Examine about the risk-based auditing, Examine about the Risk-based auditin...

Examine about the Risk-based auditing A risk based audit will be reviewing the risk management process and considering main risks of the organisation as a whole. Risk manage

Distinguish between a promissory note and a bill of exchange, QUESTION ...

QUESTION (a) "A promissory note is an instrument in writing (not being a blank or a currency note) containing an unconditional undertaking, signed by the maker, to pay a certai

Standard communication protocol used for the internet, Question: (a) W...

Question: (a) What is a computer virus? List and explain the different type of computer viruses? (b) List 4 steps which you can use to minimize the chances of being infec

Show market risk in systematic risks, Market risk as that portion of total ...

Market risk as that portion of total variability of return caused by the alternating Forces of bull and bear markets. When the security index moves upward haltingly for a signifi

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