Cash flow matching is a Buy and Hold investment strategy to meet future liabilities.
Within the strategy what we need to do is buy bonds such that we can match their cash flows to our future liabilities and we start that matching process by looking at the furthest away liability first. Because that bond is then going to also earn us some coupon or interest income in earlier years as well typically. We then work backwards to be able to match off those cash flows exactly. However, we do have a limited choice in terms of which bonds we can actually use to fulfill this strategy. So by wave example, let's assume that we have the following liabilities over the next three years. We've got a liability of 113 that falls due in a year's time a liability of 210 in two years time and a liability of 102 in three years time. The cash flow matching approach says we should match that furthest away liability the 102 in year 3 first, so we need to buy a bond that will give us 102 of cash in three years time and it just so happens that there is a bond that matures in three years time out there that has a 2% coupon. Well, this is quite nice if we buy a hundred dollars of par value in year three, we'll get a hundred dollars of par value back and the two dollars of coupon to give us a hundred and two dollars in year three. But we will also get two dollars at the end of year one and at the end of year two as well. But by buying this Bond and by buying $100 of par value of this Bond, we will be able to match the furthest away liability.
So we've got the year three liability covered now, we now need to go on to the year 2 liability and there's some good news here. Even though we've got a liability of 210 that we need to meet at time two. We've already got two dollars of that covered with the coupon on our three maturity Bond. So when we go to think about buying another bond to meet the liability for year two, we've already got some of that 210 coupled. So we only need to buy a bond that will generate Us $208 in year two. Which when taken together with the two from the three-year Bond will get the 210 that we need to meet that liability for you to. So, let's assume there is a bond out there again. That's got two used to maturity. Perfect. And it happens to have a 4% coupon. Well, this is also super helpful for us. We want cash flows of 208 from this bond in two years time. Well if we were to buy $200 of par value. We would get the $200 back and the 4% coupon. So another $8. In year two which when taken together with the $2 coupon on the three year bond would give us enough money to meet that to your liability. Fantastic.
In addition though. We're also going to get the eight dollars of coupon after the end of the first year So now we can see by buying this to your bond. We cover a year to liability. But we also make further contributions towards the year one liability as well through that $8 of coupon for Year One. So now we come back to the year one liability. We've already got two dollars from the three ear bonds coupon. We've now got another eight dollars from the two year bonds coupon. So we've got $10 already that we're going to receive in one year's time. So we only need to buy a bond that will generate us another 103 dollars at the end of year one and let's say that happens to be a one year bond out there that has a 3% coupon and if we buy a hundred dollars of par value of that bond that will give us a hundred and three hundred of par value and three of coupon that we need when taken together with the other two bonds that we've already bought that will give us enough cash to meet the hundred and thirteen dollar liability in Year One.
As you might have seen as we've gone through this example, we do need very specific ones with specific matching time frames to be able to adopt this strategy.
