What is the difference between cash flow matching and immunization in bond portfolio management?

• A. Cash flow matching tries to perfectly meet liabilities with bond cash flows; immunization uses duration and convexity to shield against small rate movements.
• B. They are identical concepts.
• C. Immunization guarantees returns regardless of rates.
• D. Cash flow matching focuses on duration while immunization matches cash flows exactly.

Answer: (A)

The idea being tested is how two bond management techniques handle timing of cash flows and sensitivity to interest-rate changes. Cash flow matching seeks to fund every liability exactly with bond cash flows that come due on the same dates. In practice this is a precise, deterministic approach: you choose bonds whose coupon and redemption payments align with the liabilities, so when a payment is due you have cash to meet it. This approach minimizes funding risk by locking in the payment schedule, though it can be rigid and may require many bonds or even constraint you if no exact matches exist.

Immunization takes a different route. Instead of exact cash-flow timing, you set the assets’ interest-rate sensitivity to align with the liabilities’ timing risk. By matching the duration (and often convexity) of the assets to the liabilities (or to a target horizon), small parallel shifts in interest rates leave the net funded position relatively stable. The goal is to protect the portfolio’s value against rate movements rather than to lock in every cash-flow date exactly.

So, cash flow matching is about precise alignment of bond receipts with liability dates, eliminating timing mismatch, while immunization is about hedging interest-rate risk through duration and convexity so the overall funding status remains stable under small rate changes. The other statements aren’t correct because they either claim they’re identical, promise rate-proof returns, or misstate what each technique emphasizes.