What does cash flow matching involve?

Cash flow matching involves ensuring that cash inflows from investments align with cash outflows required for future liabilities. This technique is particularly relevant for institutions like pension funds or insurance companies, where predictable liabilities need to be funded at specific future dates. By matching future liability payouts with bond cash flows, the institution can mitigate the risk of not having sufficient funds available when liabilities are due.

For example, if an entity has a liability that will require a payment in 5 years, it can invest in bonds that mature at that time and provide the necessary cash flows. This minimizes the uncertainty and risk associated with market fluctuations, making it a stable and reliable strategy for managing cash needs.

In contrast, investing in diversified equity funds typically involves a higher level of risk and may not ensure that cash flows will align with specific financial obligations. Using derivatives to hedge currency risks focuses on protecting against fluctuations in currency values rather than aligning cash flows for liabilities, while frequent rebalancing of asset allocations generally targets overall portfolio risk and return rather than matching cash flows to specific payout timelines. Thus, option B accurately captures the essence of cash flow matching.