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Exact matching in finance refers to strategic management of a bond portfolio wherein the lowest cost portfolio that generates cash inflow is exactly equal to the cash outflow that the investment is financing. It is part of the goal to make investment choices to achieve the largest possible return on investment. Portfolio management can be classified as either active or passive.
Active management uses specific technical analysis to make trades on a regular basis. The investor or portfolio manager is actively involved in trading securities to achieve short-term profit. Passive management is where the investment is placed in a fund that is set up with certain percents in a variety of investment securities. Investors in this case do not directly choose where the funds are allocated.
Two types of passive strategies are the buy-and-hold technique and the indexing strategy. The indexing system attempts to build a portfolio that will give an exact matching of the performance for a selected bond portfolio index. It is chosen on the capability of tracking the index. A buy-and-hold technique is simply purchasing a bond and holding it to the maturity date.
Bond portfolio management has the goal of minimizing the amount of risk and maximizing the amount of return on the investment. An investor will choose a particular risk level and invest accordingly. Acceptable risk will depend on the investor’s personality and stage in life. For example, someone who is young and aggressive may choose a high-risk bond because it offers a higher interest rate. A retiree, however, may be less willing to accept the high risk and invest more conventionally.
Exact matching techniques include elements from both the passive and active management strategies. The investor or manager attempts to match liabilities due at certain times to a portfolio of bonds to mitigate exposure to interest rate increases. Around-the-clock monitoring and multiple transactions are required to achieve the goal of avoiding or reducing risk.
The most conservative exact matching method is the pure cash-matched dedicated portfolio. A bond portfolio is established that offers a series of payments and maturing bonds that generate exact matching between the payments and future obligations. Bonds that are set up for pension fund payouts or college tuition fall within this category. This strategy is a passive portfolio that would not require reinvestment. There are also dedicated cash-matched portfolios that use a smaller initial fund that gives early payouts and then are reinvested.
The most important element of an exact matching strategy is the ability to have the required amount of funds at a time when those funds are needed. Risk is a factor that depends on the specific investor and his or her goals. No matter the specific goals and acceptable risk involved, investors typically exercise caution in choosing the securities that will best fit their situation.
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