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Chapter 13, Solution 13.5

S

shinmo

Member
Cash may not match liability
(1) In terms of impact of unexpected changes in rate of inflation
(2) In terms of uncertainty resulting from need for frequent reinvestment of cash
Can you explain how the 2 factors explain how cash may not match liability?

Thanks:)
 
(1) If inflation was suddenly to increase significantly then the liabilities of the scheme would increase (as payments are made in line with inflation). The value of cash wouldn't increase in the same way, which would lead to a mismatch.

(2) Cash is likely to produce an income stream (in the form of interest payments) or it may be invested over very short durations (as is the case with money market instruments). Either way, these cashflows will need to be reinvested, but the terms under which this can be achieved aren't known in advance and so is a risk. This uncertainty presents a challenge when trying to match a liability.
 
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