Fixed income -- page 65 -- cash flow matching

CFA Level III Fixed Income
#1

I understand the concept of cash flow matching but am stuck on one point at the bottom of page 65.

I get that cash-in advance constraint means we need sufficient funds before each liability payment date to meet obligation. Then it says

the design of traditional bonds – fixed coupon rate and principal redemption at maturity – is a a problem if liability stream is a level payment annuity. That scenerio would lead to large cash holdings between payment dates and therefor cash flow reinvestment risk.

So, I understand why excess cash would lead to reinvestment risk but I don’t get how this scenerio leads to excess cash flow. Why does a liability with level payment annuity lead to excess cash?

Thanks

#2

Because bonds typically pay coupons semiannually, so you have cash that you’re holding for 6 months waiting to make the annual payment.

#3

Thanks. Something simple if explained saves so much time.

Glad I asked.

Thanks again.

#4

My pleasure.

#5

Dear Magician, you are always great.

However, I have one more confusion. As I am holding cash in between payment dates to make liability payment, I don’t require to reinvest that fund any more. If I am right, then how the reinvestment risk has been emerged.

Thanks.

Regards,

Jahid.

#6

You’re very kind, Jahid.

Suppose that one year from today you have a fixed payment of $1,060,000 due. You’d like to invest cash today to cover that payment, and, as luck would have it, you can buy semiannual-pay 1-year bonds that pay a coupon of 6%. Would you buy $1,000,000 par of those bonds?

In a word: no.

You know that you’ll receive a $30,000 coupon payment in 6 months which you can invest for the remaining 6 months. Knowing that, you should purchase less than $1,000,000 par; the exact amount will depend on the (6-month) reinvestment rate you assume (i.e., guess) that you will get 6 months from today.